The People’s Bank of China (PBC) recently raised interest rates in the interbank market and on its medium-term lending facility. These moves came against the background of a firming domestic economy and the end to producer price deflation. The Chinese authorities project economic growth for 2017 at 6.5 percent, a rate broadly in line with forecasts by international financial institutions and market analysts. Externally, the US Federal Reserve raised interest rates in March, and indicated that further increases are likely during 2017.
The PBC’s move was small and its impact on the broader economy is likely to be very limited, but its signal of addressing financial risks is welcome. The financial risks are reflected in the intertwined problems of rapid credit expansion and high corporate debt. Since the global financial crisis of 2008, economic growth in China has been supported by a huge increase in credit. Total credit (as measured by total social financing which includes traditional bank lending and new forms of financial intermediation referred to as shadow banking) rose rapidly from about 120 percent of GDP in 2008 to over 200 percent of GDP in 2015. While this provided a much-needed boost to domestic and global demand during the global financial crisis, the reliance on credit for growth has created risks for financial stability.
In its most recent annual consultation report on China, the IMF pointed out that the credit boom resulted in a credit-to-GDP ratio in China that is high in international comparison. International experience shows that banking crises or prolonged declines in GDP generally follow credit booms similar to that experienced in China. Furthermore, potential losses from such a rapid and inefficient credit expansion could be large. The IMF’s Global Financial Stability Report of April 2016 estimated potential losses of 7 percent of GDP on corporate loans. Additional losses can be expected in other parts of the financial system, especially in shadow credit products. All this is not to predict a financial crisis or hard landing for China, but rather to highlight the priority that must be given to reduce financial stability risks.
The Chinese authorities are well aware of the need to enhance financial stability. According to the government’s work report released in March, a key task is to build a firewall against financial risks and keep a careful watch on non-performing assets, bond defaults, shadow banking and Internet finance. Priorities should include strengthening banking regulation and supervision, in particular loan classification and provisioning regulations to encourage banks to proactively recognize non-performing loans, fortify their capital buffers and strengthen their liquidity and funding risk management. The strict enforcement of the new regulations on shadow banking products is also a priority for reducing vulnerabilities.
The rapid build-up of corporate debt in China mirrors the huge expansion in credit. IMF data shows that China’s corporate credit-to-GDP ratio is also high compared with countries at China’s level of per capita income. Moreover, corporate fundamentals in China have weakened as indicated by rising intercorporate payments arrears, increasing defaults and downgrades and the rising share of debt owed by companies with weak interest coverage.
Accordingly, enhancing financial stability goes beyond monetary policy and requires a comprehensive approach to deal with the corporate debt problem. This requires further progress on State-owned enterprise (SOE) reforms, especially stopping the financing of weak firms, hardening SOE budget constraints and restructuring or liquidating over-indebted nonviable firms. Losses should be recognized and shared by the relevant parties, including the government if necessary. The lessons of Japan’s lost decades with zombie lending to bankrupt firms are relevant in this context. Zombie firms – kept alive by forgiving banks not ready to recognize loan losses – trap labor and capital in dying industries, thereby withholding them from more promising innovative industries that are needed to spur economic growth and resulting in economic stagnation. SOE reforms should be complemented with targeted social safety nets for displaced workers and assistance in training to improve their prospects for new employment.
Against the backdrop of rising interest rates in the US, some have argued that the PBC also needs to enter a tightening cycle to prevent capital outflows and stabilize the yuan’s exchange rate. However, the US and China are at different cyclical positions and their monetary policy needs are not the same. Monetary policy in China should be tailored first and foremost to domestic needs, but of course it will have external implications. Rather than rely primarily on interest rates, capital outflows can be managed with macroprudential and capital flow management measures, which the PBC has deployed in recent years. The PBC has also taken steps toward an effectively floating exchange rate regime and can build on this progress by allowing greater exchange rate flexibility.
The PBC faces difficult challenges on monetary policy in the period ahead against the backdrop of an unsettled global environment. It needs to maintain an accommodative stance to support activity, while giving priority to enhancing financial stability by reining in credit growth. Urgent progress is needed to address the corporate debt problem through SOE reforms. Capital outflow pressures should be addressed primarily with macroprudential and capital flow management measures, while further progress can be made on exchange rate flexibility.
- Liu Xiangbo：Inflation and Economic Growth—— A Hump-shaped Relationship