The Two Instabilities

As the 11th National Committee of the Chinese People’s Political Consultative Conference, the country’s top political advisory body, meets in Beijing to ratify a new five-year plan to rebalance the economy and to tackle inflation and rising property prices, two comments from western China illustrate the Morton’s fork China’s economic policymakers find themselves somewhat uncomfortably stuck by.

The first occurred at a recent meeting of regional managers from one of the large state-owned banks. A manager from Xinjiang, we are told, complained that credit quotas imposed by the banking regulators were constantly tightening in the cause of the national fight against inflation, making his bank’s branches unable to meet the local demand for loans, demand that was rising because of the development priority now been accorded to the region by Beijing.

The central bank is repeatedly dabbing up as much of the excess liquidity in the economy as it can through interest-rate hikes, higher capital reserves requirements on banks and administrative measures such as new-loan quotas. The goal is to dampen inflation and to let down the asset bubbles inflated by the lending spree triggered by the post-global-financial-crisis stimulus.

Yet it is precisely through fixed-asset investment that the government has been able to deliver the constant economic growth that the Party sees as essential to legitimize its monopoly on power. The second comment, from Xinjiang regional chairman Nur Bakeri just this week, spells out how raising living standards through economic development is key to maintaining social stability. “Development is our top priority and stability is our greatest responsibility. Without development, there would be no stability and vice versa,” he said.

Such local political pressures lie behind not just the continued pace of new bank lending this year, but also the discovery in February by the banks’ regulator, China Banking Regulatory Commission (CBRC), that more than half of new bank lending wasn’t meeting its new credit rules designed to mitigate the fear that China’s banks are sitting on a potential dung heap of bad loans. The rules require banks to meet tougher credit and risk standards with new loans. As far as the banks are concerned it is a case of old habits die hard. For years and years and years, China’s growth has been fueled by fixed asset investment financed through government-directed bank lending. Flash the cash and the devil take the hindmost.

Beijing had to bail out the big banks once to cleanse their loan books. After a couple of years of stimulus fueled record lending, it worries it may have to do so again. The recent turn to the capital markets by the big four state-owned banks has been in part to replenish threadbare capital cushions.

The CBRC has recently read the riot act to the banks for their continued lax lending. More detailed — for which read, stricter — regulations on things like capital adequacy and leverage ratios are likely to be announced later this month or early next, once the horse trading between the regulators, the industry and the myriad of official agencies with an oar to shove in to in these particular waters, has been completed. These will bring China broadly in line with international standards, and in some cases be much tougher.

They won’t completely mitigate the regulators’ darkest fears about bad loans. The CBRC is still acutely concerned about banks’ lending to the captive investment vehicles of local governments intended to get round restrictions on direct capital raising from banks. Banks had lent at least $1.2 trillion this way to local governments as of June 30th, with 23% not backed by cash flows. The CBRC’s new rules in February were particularly tough in this regard, as they were for real-estate lending. As we noted earlier, regulators have reportedly told banks to recalculate their capital levels using higher risk weightings for their loans to local governments via captive investment vehicles. It will be a nervous-making wait for the results. As the finance ministry noted in its budget report, “local governments face debt risks that cannot be overlooked”.

How much the Party can risk slowing down the economy  to minimize the risk of a hard landing if bubbles go pop and yet still keep real living standards rising is the calculation that now has to be made in Beijing. Late last month Prime Minister Wen Jiabao set an expectation that annual growth rates will slow. He said the government would target 7% annual GDP growth for 2011-15, though it wasn’t so long ago that growth of 8% a year was said necessary to generate sufficient jobs to absorb new workers coming onto the labor market and thus ensure social stability. Diverting GDP growth into social services and income-tax cuts to offset the effects of inflation is now seen as a greater guarantor of stability than providing jobs, it appears, to a government that is seemingly increasingly if unnecessarily rattled as it enters a period of economic, political and foreign-policy transition.

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