The dragon’s narrowing policy horizons

Back in the last quarter of 2011, when the decline in China’s investment growth accelerated, concerns about a hard economic landing intensified, particularly given the authorities’ reluctance to pursue new expansionary policies.

By May last year, however, the government had changed its mind, with the National Development and Reform Commission approving 7 trillion yuan (S$1.4 trillion) in new projects. That, together with two ensuing interest-rate cuts by the People’s Bank of China (PBOC), guaranteed an end to the slowdown in the third quarter of last year.

The Chinese economy’s performance has thus maintained the cyclical pattern familiar from the past two decades: Rapid investment growth, supported by expansionary policy, drives up the economic-growth rate.

Inflation follows, so policy is tightened and growth slows. But inflation remains high or rising, so more tightening is imposed. Inflation falls at last, but growth slows more than desired, owing to the overcapacity that resulted from excessive investment in the earlier phase of the cycle.

At this point, policy becomes expansionary again, and the cycle begins anew: Led by investment growth, the economy rebounds. Thus, the acceleration of economic growth since the third quarter of 2012 should come as no surprise. With the government still having room to wield expansionary monetary and/or fiscal policy, the economic revival was only a matter of time.

TWO CAVEATS

There is no reason to doubt that the Chinese economy this year will follow the old growth pattern. But China’s decision-makers should bear two things in mind.

First, in the past, short-term macroeconomic stability was often achieved at the expense of structural adjustment and rational allocation of resources. To achieve sustained growth, a balance between short-term and long-term objectives must be struck. Striking that balance is the biggest challenge facing China.

Second, some financial vulnerabilities are embedded in the economy. Unless they are defused in time, financial shocks may derail the economy from its normal growth path.

According to preliminary reports, annual investment growth last year reached roughly 14 per cent — significantly higher than the gross domestic product (GDP) growth rate, which accelerated in the fourth quarter as a result of a strong rebound in investment in real estate and infrastructure.

This year, it can be expected that, barring major disruptions, strong investment growth will push China’s GDP more than 8 per cent higher year-on-year.

The timing of the inevitable policy shift back to tightening depends on overall inflation, particularly house prices. The problem is that the investment share of China’s GDP is already about 50 per cent, while double-digit investment growth this year is expected to push that rate still higher. Such a growth path is simply not sustainable.

The money supply has grown significantly faster than output for decades. Last year, the growth rate of M2 was about 14 per cent, relatively low by historical standards, but still significantly higher than the nominal GDP growth rate.

As a result of this chronically rapid growth in broad money, China’s M2/GDP ratio has surpassed 180 per cent, the highest in the world. Though the full implications of this uniquely high ratio for macroeconomic stability need further investigation, it certainly implies financial fragility and a weakening of the PBOC’s ability to control overall liquidity in the economy.

Moreover, though China’s public debt/GDP ratio is officially still under 20 per cent, since the onset of the global financial crisis in 2008, its fiscal position has deteriorated. If the government’s contingent liabilities are included, China’s debt/GDP ratio may be closer to 50 per cent.

COLLAPSE OF SHADOW BANKING SYSTEM?

A worrying development in this regard is the rapid rise in enterprise debt, which, according to various studies, now surpasses 120 per cent of GDP — much higher than the leveraging rates of non-financial enterprises in major developed countries.

Even if this does not trigger a crisis, it sharply narrows the government’s scope for using expansionary fiscal policy to stimulate the economy.

In 2011 and early last year, there was much talk of a crash in China’s housing market, and a chain-reaction of defaults in underground credit networks and local-government finance platforms. This year, the talk has changed to the danger of a resurgent housing bubble and the collapse of the shadow banking system, which consists mainly of wealth-management firms and trust companies.

According to market sources, total assets managed by the shadow banking system have risen exponentially since 2009, totalling 14 trillion yuan, or one-third of GDP, in the third quarter of 2012. With relatively slow growth, corporate profitability, upon which the returns of the shadow banking system’s asset pools are based, is low and falling.

Where, then, will the high returns of the financial products provided by the shadow banking system come from?

If the shadow banking system collapses, the consequences for the financial system will be much graver than the problems caused by underground credit networks and local-government finance platforms, which were much discussed last year.

No wonder, then, that one influential banker regarded as a possible successor to PBOC Governor Zhou Xiaochuan has warned of the possibility of a “Chinese-style subprime crisis”.

For now, the Chinese economy, having received its cyclical does of stimulus, should be okay. By the end of the year, however, the costs of the structural adjustment needed to shift China’s growth model away from investment demand could rise further.

Yu Yongding is a former President of the China Society of World Economics and Director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, and has also served on the Monetary Policy Committee of the People’s Bank of China.