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2 China’s debt concerns and subsequent policy responses

2 China’s debt concerns and subsequent policy responses

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108 René W.H. van der Linden



140



10



130



8



120



6



110



4



100



2

1997



1999



2001



2003



2005



2007



2009



2011



China’s current account to GDP (%)

(dashed line)



domestic credit private sector (% of GDP)

(solid line)



Over the past decade, the national savings have amounted to about

50 per cent of GDP partly because households have had few attractive

avenues for savings. In addition, the government channelled the excess

savings into SOBs which lend it to SOEs at low interest rates relative

to the pace of economic growth in order to finance domestic investments. The Chinese authorities could count on households to save due

to powerful precautionary motives as part of the ‘iron rice bowl’ welfare

system coming from the Mao era. After the dismantling of this ‘cradleto-grave’ social security system during the 80s and 90s, employment

eroded and households faced increased income volatility along with

prospective new spending needs for education, health care, housing and

retirement (Cecchetti and Schoenholtz, 2014).

The current situation nonetheless offers a real reason for concern. In

the 1990s, China’s debt-to-GDP ratio, similar to its financial credit, at 25

per cent, was far lower than most developed countries. However, since

the start of the credit crisis this ratio increased from 147 per cent in 2008

to more than 250 per cent of GDP in 2014. Especially, the fast increase

of this debt in such a short time is worrisome since in other economies

this often led to a financial collapse. It is evident that China has less

room to manoeuvre now than it did 20 years ago since 60 to 70 per

cent of new lending is going to service the old debt (VanderKlippe and

Reguly, 2014). Debt appears to have been deployed less efficiently in

the past few years, highlighting the need for structural reforms to boost

the efficiency of investment decisions. Since most borrowing in China

finances investment rather than consumption, the deterioration in efficiency worsened markedly after the credit crisis of 2008–09, partly due

to the sharp decline in returns on investment (CEIC, 2014b). The question is to what extent China’s debt-to-GDP ratio can continue to rise,



2013



Figure 5.1 The relation between China’s domestic credit to private sector

(percentage of GDP) and its current account (percentage of GDP)

Source: Mian, A. and A.Sufi, 2014 (data source: Worldbank)



China’s Shadow Banking System



109



taking into account that more investments are made in non-productive

projects and more debt is being used to repay old debts.

Since 2003, China no longer had to boost domestic demand through

the creation of more domestic credit. Foreign investors were willing to

borrow hundreds of billions of dollars every year to purchase Chinese

products. As shown in Figure 5.1, the result was a rapid increase in China’s

current account surplus from about 2.5 per cent of GDP in 2003 to over

10 per cent of GDP in 2007. In other words, instead of creating domestic

debt to boost demand for its goods, China could rely on foreign investors

to generate demand for its goods which resulted in a reduced pressure on

domestic debt creation (Mian and Sufi, 2014). However, since the start

of the credit crisis which accelerated a sharp fall in export demand from

developed countries, the global demand for Chinese goods collapsed.

The Chinese government has responded to this declining demand by

stimulating a structural shift from export-led to more investment-driven

growth, most of which has been debt financed (Manulife, 2014). The

current account surplus declined from over 10 per cent of GDP in 2007 to

about 2 per cent in 2011, which put severe downward pressure on China’s

growth rate. In order to create new demand for its productive capacity

the Chinese government stimulated a rapid rise in domestic corporate

debt through extensive domestic credit creation by the SOBs (Figure 5.2).

Since 2008, China has seen an explosive growth in domestic corporate

debt partly because its shadow banking sector is strongly related to local

government debt and real estate development (Mian and Sufi, 2014).

In the present state of affairs there is still a key role for the government

in the allocation of investments, whereby lending and deposit interest

rates remain regulated and lending quotas are set by the government. A

still existing ‘financial dependency triangle’ between the State Council,

SOBs and SOEs has meant that there are still huge capital flows being

35%

30%

25%



Our measure of total

credit, y/y %



20%

15%

10%

Nominal GDP, y/y %

5%

0%

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014



Figure 5.2 The deleverage challenge: China’s total credit and nominal (GDP, y/y%)

Source: CEIC (2014a), Standard Chartered Research



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René W.H. van der Linden



channeled to large and inefficient SOEs in key infrastructural industries,

many of which are facing significant overcapacity while causing difficulties for Small- and Medium-sized Enterprises (SMEs). It has become more

apparent that this high level of lending to SOEs is beginning to deliver

diminishing returns (Manulife, 2014). Since 2009 until early 2012 and

once again between 2012 and 2014 the gap between total credit and

nominal GDP growth has widened significantly which partly explained

the excessive debt growth since 2009 (CEIC, 2014a).

While the advanced economies were experiencing the adverse effects

of the credit crisis, China was undergoing a period of monetary expansion, to the point that its credit-to-GDP expansion became an issue to

worry about. Both the size of the local government liabilities and the

private sector have contributed significantly to the leverage problem

within the economy, whereby the vulnerabilities lie mainly within a

small group of large SOEs which has over-extended and accumulated

large debts. When it comes to household debt, mortgage liability

increases remained fairly in line with the income growth; therefore,

China is facing a different type of debt concentration from the situation in the US prior to the credit crisis where increasing household debt

was the primary factor for expansion of the housing market. The key

question is whether the central government has the resources to handle

the corporate debt problems with almost USD 4 trillion of reserves and

a relatively low overall government debt level as a share of GDP. From

2008 the Chinese government has put a lot of pressure on expanding

growth in order to reduce the adverse effects of the credit crisis. In late

2008 it boosted its spending with a 4 trillion RMB (about USD 600

billion) economic stimulus program which is mainly based on credit

creation (Sharma, 2014).

Since 2010, several restrictive monetary policy measures have been

imposed by the China Banking Regulatory Commission (CBRC) which

supervises banks and is the prudential regulator of banks as well as

non-banking lending institutions. These measures include the raising

of credit rationing, interest rate controls and the required reserve ratio

(RRR), which is around 20 per cent and is much higher than in the

US (about 10 per cent) and EU (about 1 per cent). A high RRR reduces

banks’ ability and willingness to lend to high-risk companies like SMEs,

which are therefore forced to obtain funding through off-balance-sheet

activities mainly offered by shadow banks. During the Shibor crisis in

June 2013, there was a peak in the Chinese bank repo rate revealing an

interbank liquidity problem and a falling credit growth. A high repo

rate increases banks’ financing costs on WMPs, thus increasing default



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risk. It also puts pressure on mortgage rates, resulting in reduced speculative investments in real estate, in turn driving housing prices down.

Also, the Chinese middle-class is increasingly willing to evade capital

controls and take their money out of the country, and declining capital

inflows constrain the Chinese banks’ capacity to lend. As a result of

these developments, deposits in the banking system are becoming less

stable. Although the PBC has made efforts to tighten credit and rein in

shadow banking, the consequences for a lurking credit crunch still exist.

Currently the SOBs financial performance is rather successful, but there

is a threat that a wave of ‘bad debts’ will soon hit them. Since China’s

reservoir of cheap labour is running out, the authorities rebalance their

economy in order to pour less credit into SOEs in favour of households

and private firms. The policy makers also have developed a new set

of guidelines in 2014 which aims to regulate risky off-balance-sheet

lending in order to curb the riskiest practices of shadow banking and at

the same time encourage the rise of non-bank lending as an important

funding source for weak borrowers and as a means to diversify China’s

bank-based financial system (Thomson Reuters, 2014). The development of China’s monetary policy of the last decade resembles a ‘see-saw’

movement. Since the 2007–08 boost, 2010–12 contraction, 2012–mid

2013 expansion, mid-2013–end 2014 contraction and the current policy

easing, the authorities keep on fine-tuning their economy by sometimes

tightening and sometimes loosening the reins. At the same time the

‘financial dependency triangle’ between the State Council, SOBs and

SOEs still appears in part to exist by favouring SOEs more than private

firms which are becoming more dominant in the financial sector

(Linden, 2010 and 2012).



5.3 The nature of China’s shadow banking and a

comparison with its Western peers

There is currently a considerable debate among Chinese stakeholders

about the merits and demerits of shadow banking. Proponents of more

shadow banking stress the increasing economic efficiency through disintermediation, that is, providing financing outside of traditional banking

channels and increasing investors’ welfare by giving them chance to

tailor portfolios to their preferences. Also, shadow banking provides a

larger variety of financial products and services through diversification

and decentralization. A decentralized financial system can mitigate the

‘too big to fail problem’ and resist shocks in the financial system. If losses

are shared by many SMEs, some would be able to fail without necessarily



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René W.H. van der Linden



threaten the market stability (Schwarcz, 2013). The emergence of shadow

banks is an inevitable result of financial development and innovation. As

a complement to the traditional banking system, shadow banks play an

active role in serving the real economy and enriching investment channels for ordinary citizens. The shift from indirect to more direct finance

will improve efficiency of fund use, and well-conceived and balanced

financial reforms have maximized the benefits of shadow banking while

controlling the risks involved. However, some critics argue that shadow

banking is not properly regulated, and its scale and rapid growth does

raise debt levels and make credit flows less transparent and more risky.

The main risks resulting from shadow banking are liquidity risk due to

maturity mismatch and default risk from loans to weaker companies or

projects. Shadow banking has also contributed to rising corporate indebtedness due to insufficient regulation and poor risk management. Also,

contagion risk increased due to the non-transparent and interconnected

nature of shadow banking, and the moral hazard problem is exacerbated

since the government will always step in to save the borrowers from

default. These arrangements have encouraged crony lending practices

and the concealment of non-performing loans (NPLs). In recent years,

the problems of moral hazard, related-party lending, and loan forbearance have been particularly prevalent in the area of ‘local government

finance vehicles’ (LGFVs), a set of entities set up by the local governments to raise funds primarily for costly infrastructure and real estate

development projects (see Section 5.5). There are a few tools available

to quantify or identify these risks clearly. The problem issue is not the

size but more the rapid growth and increasing complexity of shadow

banking. Profit opportunities for players in the shadow banking activities come from financial repression which distorts the cost of capital and

investment returns, regulatory restrictions on lending and high demand

for loans from many private SMEs. Shadow banking could be considered

as a risk to the financial soundness of the financial system, and investors

are worried that defaults in the banking system could trigger a financial

crisis. Especially from early 2014, there have been several defaults of

trust products (TPs), and the market perception of risk has been heightened since the PBC restricted funding to the interbank lending market

in 2013. However, these concerns are tempered by the authorities’ vast

financial resources and ability to exercise central control (Summers and

Haskins, 2013).

Although the specific content of shadow banking varies from country

to country as financial systems differ accordingly, in Western economies



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