The Days Of The Super-Powered Chinese Economy Are Over; What China Central Bank Learned From Past Credit Crunches

The Days Of The Super-Powered Chinese Economy Are Over

06/28/2013 20:36 -0400

Authored by Michael Pettis, originally posted at Foreign Policy,

In the months leading up to last week’s liquidity crunch, in which the cost of short-term loans in China spiked and roiled global markets, most financial institutions had been lowering their growth forecasts for China. In mid-June, the World Bank revised its 2013 Chinese growth forecast from 8.4 percent to 7.7 percent; HSBC, Credit Suisse, and Goldman Sachs, among others, have also downgraded their Chinese growth forecasts several times over the last two years, as quarterly data have kept revealing lower-than-expected economic growth and higher-than-expected credit growth. Many banks now estimate around 7 percent to be the new normal.But the banks’ numbers are likely still too high. China’s economy is at a turning point in its transformation from one driven by export and investment to one driven more by domestic household spending. Growth predictions are underestimating the impact of this shift.

The recent liquidity crunch, and its cause, illustrates some of the difficulties China’s economy will face in the future. Over the last two years, and especially in 2013, mainland corporations with offshore affiliates had been borrowing money abroad, faking trade invoices to import the money disguised as export revenues, and profitably relending it as Chinese yuan. As China receives more dollars from exports and foreign investment than it spends on imports and Chinese investment abroad, the People’s Bank of China, the central bank, is forced to buy those excess dollars to maintain the value of the yuan. It does this by borrowing yuan in the domestic markets. But because its borrowing cost is greater than the return it receives when it invests those dollars in low-earning U.S. Treasury bonds, the central bank loses money as its reserves expand. Large companies bringing money into the mainland also force the central bank to expand the domestic money supply when it purchases the inflows, expanding the amount of credit in the system.

In May, however, the authorities began clamping down on the fake trade invoices, causing export revenues to decline. Foreign currency inflows into China dried up, as did the liquidity that had accommodated rapid credit growth. The combination of rapidly rising credit and slower growth in the money supply created enormous liquidity strains within the banking system. This is probably what caused last week’s liquidity crunch and this week’s market convulsions.

The surprising thing about this process has been the government’s determination to see it through. Policymakers in Beijing have not backed down from the implications of rebalancing China’s economy away from its addiction to investment and debt, even though economic growth is slowing and banks are pleading with the government to turn back on the liquidity spigots. Whereas the administration of President Xi Jinping’s predecessor, Hu Jintao, never allowed growth to slow much before losing its nerve and increasing credit, Xi seems determined to stay the course.

There are two important lessons to be drawn from last week’s panic.

First, the central bank and the leadership in Beijing seem determined to try to get their arms around credit expansion — even if that means, as it absolutely must, that growth will suffer and the banks will come under pressure. The extent of the freezing of the money markets on June 20 surprised many, including probably the central bank itself, but there will likely be more disruption in the markets over the next few years as Beijing tries to control what has become a runaway process.

Second, reining in credit won’t be easy: the financial system and a whole host of borrowers — including real estate developers, capital-intensive manufacturers, and local and municipal governments — are too addicted to rapid credit expansion. Attempts to constrain credit growth will create significant strains in the financial sector, as borrowers find it hard to roll over debt that they cannot otherwise repay. Constraining credit growth will also mean a significant reduction in economic activity over the next decade.

Last week is a reminder that Beijing is playing a difficult game. The rest of the world should try to understand the stakes, and accommodate China’s transition to a more sustainable growth model. As policymakers in China continue to try to restructure the economy away from reliance on massive, debt-fueling investment projects that create little value for the economy, the United States, Europe, and Japan must implement policies that reduce trade pressures. Any additional adverse trade conditions will further jeopardize the stability of China’s economy, especially as lower trade surpluses and decreased foreign investment slow money creation by China’s central bank. A trade war would clearly be devastating for Beijing’s attempt to rebalance its economy and have potentially critical implications for global markets.

Regardless of what happens next, the consensus expectations that China’s economy will grow at roughly 7 percent over the next few years can be safely ignored. Growth driven by consumption, instead of trade and investment, is alone sufficient to grow China’s GDP by 3 to 4 percent annually. But it is not clear that consumption can be sustained if investment growth levels are sharply reduced. If Beijing can successfully manage the employment consequences of decreased investment growth, perhaps it can keep consumption growing at current levels. But that’s a tricky proposition.

It’s likely that the days of the super-powered Chinese economy are over. Instead, Beijing must content itself with grinding its way through the debt that has accumulated over the past decade.

hat China Central Bank Learned From Past Credit Crunches

In signaling this week that it was prepared to inject liquidity into the markets, the People’s Bank of China brought the country’s financial system much needed relief that a “Lehman moment” might be avoided.

The current credit crunch, in which the central bank has refused to act as the lender of last resort, differs markedly from two previous episodes, in the late 1980s and early 1990s. It also shows that China’s approach to macroeconomic governance has evolved: Its leadership no longer relies solely on political and administrative controls, and is allowing market forces take a greater role.

For much of the 1980s, the central bank had to rely on strict enforcement of credit quotas to contain economic overheating, even though reserve requirements had been introduced and the central bank could regulate credit to the banking system. This was essentially a form of financial planning. The first crunch, in the late 1980s, was triggered by a failed price-reform effort led by Premier Deng Xiaoping. It was supposed to unify the dual-track pricing system into a single regime based on market prices. But it lacked complementary wage reform and ultimately produced inflation.

Credit Controls

That cash squeeze was also partly caused by the People’s Bank’s decision to relax credit controls in response to the previous monetary tightening in the mid-1980s. The subsequent retrenchment — which included the crackdown on the protestors in Tiananmen Square — cost key reformers such as Zhao Ziyang their political careers, led to a resurgence of pro-planning conservatives and to the reversal of many reforms.

The central bank found the new market measures ineffective at restricting credit growth as long as the old planning system remained in place. Moreover, an emerging regional interbank market encouraged banks to sidestep the credit quota and to use reserves for additional lending. As a result, the PBOC’s two increases of the reserve ratio had limited impact in constraining liquidity. Instead, the government and the central bank resorted to strict administrative measures as part of an austerity program.

The PBOC subsequently reversed its experiment: Credit quotas became mandatory again, interest-rate liberalization measures were reversed and interbank lending was controlled more tightly. To deal with exceptionally high investment growth, investment quotas were established for each province. All investment projects were required to be approved at either the provincial or the national level.

These harsh measures led to an economic hard landing. In 1990, growth of industrial output declined to 6 percent, the slowest one-year growth since 1979, while gross domestic product growth fell by two-thirds. Thousands of township and village enterprises failed and thousands of rural migrant workers in urban areas lost their jobs.

The second round of credit contraction 10 years ago was another attempt to quell nationwide economic overheating. It coincided with a push for market reforms from the top, a renewed investment campaign sanctioned by local governments, an expansion of the money supply, an active informal financial sector and a lack of limits on the expansion of policy loans to subsidize the state sector.

The result was large amounts of unauthorized loans to finance fixed-asset investment, with a significant exposure to real estate, stocks and local capital-investment projects. Part of the blame belongs to the PBOC’s inability to discipline the banks and control the activities of nonbank financial institutions. Chaos ensued: The consumer price index peaked at 24.1 percent in 1994, real interest rates turned negative, and there were runs on banks and rampant disorder in the interbank market.

Reformist Premier

To avoid a repeat, the leadership focused on stability. A reformer, Zhu Rongji, who was then vice premier, took over the governorship of the central bank in July 1993, and implemented an austerity program. The package contained market-based measures, but the basic theme was once again administrative command.

There were four main policies: withdrawing loans granted without authorization, raising interest rates on deposits and loans, restraining irregular capital-raising activities, and restoring order among investments in real estate and development.

The package also was intended to strengthen the powers of the PBOC. The central bank separated the state-owned banks from their affiliated trust and investment companies, required state banks to call back all loans made outside the credit plan, restricted inter-regional lending and sent working groups to the provinces to monitor progress.

By 1997, the austerity policy had succeeded in lowering inflation to 2.8 percent, and GDP growth was brought down to a more sustainable level of 9.3 percent, from 14 percent in 1993. The second credit crunch had produced a soft landing.

The most recent tightening of liquidity appears to have been caused by a crackdown on bond-market irregularities along with a reduction in foreign-exchange inflows and by seasonal factors such as a surge in demand for cash during holidays that often lead to cash shortages.

The PBOC’s tardiness in responding to market concerns suggests the beginning of a different dynamic. The new economic leadership under Premier Li Keqiang has stated that it will put much more emphasis on market forces. For starters, the government extended Zhou Xiaochuan’s tenure as central bank governor and announced measures aimed at strengthening the real economy. This suggests that the leadership is worried about a financial crisis developing as a result of its 2009 anti-crisis lending spree, the rapid expansion of the money supply from the PBOC’s foreign-exchange intervention and the phenomenal growth of a shadow banking sector that escapes regulatory supervision.

Structural Problem

By turning off the credit tap, the authorities sent a clear message to the financial sector that the liquidity shortage was structural, and that it would have to be overcome by financial institutions themselves rather than by the central bank. By accommodating a surge in interbank interest rates, the latest action is a credible early warning that banks need to address their risk management and off-balance-sheet activities.

The bank only stepped in after the liquidity shortage led to a slump in the stock and bond markets. In light of the domestic economic slowdown and a possible exit from quantitative easing in the U.S., China’s largely regulatory-induced credit restrictions also serve as a real-world stress test of the capacity of its banking system and financial markets. It can be seen as the PBOC’s orderly exit from the austerity program.

The PBOC’s strategic decision not to intervene in the market heralds a more proactive and market-oriented approach. However, official tightening only targets the symptom, not the disease. When the party congress meets this fall, it could bring renewed momentum to financial reform in areas such as interest-rate marketization, capital account liberalization and the regulation of the shadow banking system.

(Stephen Bell is a professor of political economy and Dr. Hui Feng is a research fellow in the School of Political Science and International Studies at the University of Queensland. Their latest book is “The Rise of the People’s Bank of China: The Politics of Institutional Change.”)

Read more from Echoes online.

To contact the writers of this post: Stephen Bell at stephen.bell@uq.edu.au; Hui Feng at h.feng@uq.edu.au