Tag Archives: rebalancing

Putting Financial Stability Ahead Of Growth

IN THE SIX years since the International Monetary Fund last published a Financial System Stability Assessment of China, credit has boomed, spreading shadow banking has added complexity to the system, and moral hazard has grown as belief in the implicit state guarantee to firms and investors has remained unshakeable.

In short, financial instability risks have grown rapidly.

Within the constraint of maintaining growth and employment, authorities have responded to mitigate the risk and to put the expanding financial system on the right footing to support the ‘rebalancing’ of the economy from being led by infrastructure investment and export manufacturing to being more consumption and service driven.

There is much more to do, however, as the Fund outlines in its latest assessment.

Some of that will be politically challenging, notably allowing firms to fail, markets to fall and investors to lose money, which will be the consequences of removing the implicit guarantee that the state stands behind financial loans and products. They will also require detailed technical work on bankruptcy procedures, financial education and even social security safety nets.

Political priorities will also need to be adjusted to put financial stability ahead of economic growth. That is already starting to happen as job losses, particularly in heavy industry and primary production, and slowing economic growth more generally shows. However, the tolerance for both is greater at the higher levels of government than at the local one, where the expectation among officials that promotion depends on creating good economic growth numbers is proving hard to break. The massive task of reforming local government finances is probably a multi-decade, not just multi-year endeavour.

China Financial System Growth

Improving the supervision of the financial sector is an easier piece to bite off, and authorities have been systematically expanding that for banks, insurance companies and securities firms in recent years. The Fund recommends setting up an umbrella regulator focusing solely on financial stability to coordinate the oversight of systemic risk across sectors.

This regulator, which would be an institutional version of the recently established Financial Stability and Development Committee, will need authority and independence over the sector supervisors and an improved flow of data given the scale and complexity of the country’s financial system, especially in some of the murkier areas of shadow banking. As was seen in the West with the 2008 financial crisis, failure to monitor risks outside the regulatory perimeter can be the most damaging failure of all.

The Fund also suggests that the well-advertised rapid growth of debt requires banks to hold a plumper cushion of capital, and particularly at the larger banks that are systemically important. Greater capital reserves would not only provide a buffer in the event of a sudden or severe economic downturn, but also against the particular risk with Chinese characteristics of the extensive off-balance-sheet borrowing, notably for wealth management products, that the banks implicitly guarantee.

In the same vein, banks and financial institutions should be nudged through lending rules to stop using short-term borrowing to finance their investments and instead both lend and fund longer-term. Should it come to it, and a financial institution goes under, regulators should have their powers expanded in line with international standards to let the firm to ‘fail safely’ rather than prop it up with public funds.

Another area that the Fund urges oversight is digital finance, or fintech, which as expanded significantly in China as elsewhere. Existing oversight frameworks are often ill-fitting for the innovation that comes with fintech, though the need for systemic safety and soundness is not diminished.

The Fund calls China ‘the global centre of fintech’, noting the growth of peer-to-peer lending and the emergence of payment systems run by internet retailers such as Alibaba that are competitors to the banks’. Smartphone app WeChat’s WeBank is already a competitor to banks’ lending.

The scale of this is still small compared to the overall size of the banking system and thus not a systemic risk — yet. Nonetheless, they will need to be brought into the regulatory and supervisory scheme of things. This is starting to happen following the State Council last year launching an overhaul of internet finance oversight.

 

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China Will Rebalance The World’s Energy

Wind turbines in Xinjiang, 2005. Photo credit: Chris Lim. Licenced under Creative Commons

ACROSS THE MORE heavily industrialised provinces, factories and plants are being ordered to shut down or limit production during the winter months. This is both to curtail excess industrial production and also to curb seasonal smog, a byproduct of China being the world’s largest consumer of coal, which provides 65% of its energy.

The newly published annual outlook from the International Energy Agency (IEA) brings a glimmer of a silver lining to that particular dark cloud. China, it says, will remain a ‘towering presence’ in coal markets, but it believes coal use peaked in 2013 and is set to decline by almost 15% over the period to 2040.

China burnt 2.75 billion tonnes of coal in 2013, more than the rest of the world put together.

It is no secret that Beijing sees pollution as a potential political problem and that it is keen for China to go green. Lian Weiliang, deputy head of the National Development and Reform Commission, said earlier this week that the country was ahead of pace in its goal to cut coal capacity by 500 million tonnes within three to five years of 2016, while the Ministry of Industry and Information Technology forecast that environmental protection equipment manufacturing would be a 1 trillion-yuan ($150 billion) industry by 2020.

The new era will be about energy policy where the focus is on electricity, natural gas and cleaner, high-efficiency and digital technologies, not an energy system dominated by coal and a legacy of serious environmental problems, giving rise to almost 2 million premature deaths each year from poor air quality.

The switch will also flow from rebalancing the economy from a development model based on heavy industry, infrastructure development and the export of manufactured goods to one driven by higher-value-added manufacturing, services and domestic consumption.

Signs of the new era are there to be seen. Energy demand growth slowed markedly from an average of 8% per year from 2000 to 2012 to less than 2% per year since 2012. Official plans call for it to slow further to an average of 1% per year to 2040.

Energy efficiency regulation is a large part of the explanation. Without new efficiency measures, the IEA reckons, end-use consumption in 2040 would be 40% higher.

Nonetheless, such is the compounding effect of economic growth that by 2040, per-capita energy consumption in China will exceed that of the European Union and electricity demand for cooling alone in China will exceed the total electricity demand of Japan today.

The IEA reckons that China will need to add the equivalent of today’s United States power system to its electricity infrastructure to meet the demand expected by 2040. Such will be the scale of China’s clean energy deployment, technology exports and outward investment that it will play a huge role in determining global energy trends and in particular provide the momentum behind the low-carbon transition.

“When China changes, everything changes”, as the IEA says.

The agency lays out the future thus:

One-third of the world’s new wind power and solar PV is installed in China … and China also accounts for more than 40% of global investment in electric vehicles. China provides a quarter of the projected rise in global gas demand and its projected imports of 280 billion cubic metres in 2040 are second only to those of the European Union, making China a lynchpin of global gas trade. China overtakes the United States as the largest oil consumer around 2030, and its net imports reach 13 million barrels per day in 2040. But stringent fuel-efficiency measures for cars and trucks, and a shift which sees one-in-four cars being electric by 2040, means that China is no longer the main driving force behind global oil use – demand growth is larger in India post-2025.

China will also continue to lead a gradual rise in nuclear output, overtaking the United States by 2030 to become the largest producer of nuclear-based electricity.

The shift to a more services-oriented economy and a cleaner energy mix will take a decade to have its effects on the skies above. The IEA projects carbon dioxide emissions will plateau at only slightly above current level by 2030 before starting to fall back.

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IMF Again Warns China Off Growth For Growth’s Sake

THE IMF’S NEWLY published World Economic Outlook projects a 0.1 percentage point increase in GDP growth this year over last, to 6.8%. That is an upward revision of 0.1 percentage point to its July forecast, based on policy easing and stimulus to domestic demand earlier in the year.

However, the Fund sees the glide path of managed slowing growth resuming next year, with GDP growth forecast at 6.5% in 2018 (again up 0.1 percentage point from July’s forecast, and up 0.2 percentage points from its April forecast) and thereafter slowing further to 5.8% by 2022.

By that point, the IMF expects China to be growing more slowly than the emerging and developing Asia average, forecast at 6.3%. That would a phenomenon not seen since China started its double-digit growth spurt.

That, in its way, would be a mark of success for the rebalancing of the economy towards being more consumption-driven and less dependent for growth on infrastructure investment and exports. The IMF is projecting that China’s current account balance will have shrunk to $28.8 billion by 2022, against $196.4 billion last year, and almost one-tenth of the level it was a decade ago. As a percentage of GDP, the effect will be even more dramatic: a projected 0.2% in 2022 against 4.7% in 2009.

All neat projections, but realizing them is not without risk, most notably in managing debt:

Over the medium term, dealing with financial sector challenges will be essential. Minimizing the risk of a sharp slowdown in China will require the Chinese authorities to intensify their efforts to rein in the credit expansion.

The conundrum is that 6%-plus growth is necessary for China to have met its target of doubling real GDP between 2010 and 2020. To make sure it does, Beijing will be in no hurry to withdraw its stimulus.

However, as this Bystander and others have noted before, delay comes at the cost of further increases in debt, making the issue more difficult to resolve through the necessary measures of tighter supervision, reined-in expansion of credit and writes down of the underlying stock of bad assets.

This, in turn, would slow rebalancing and reduce the policy space available to respond in case of an abrupt shock to the system, internal or external.

Such shocks are not difficult to imagine, and are detailed by the Fund:

a funding shock in the short-term interbank market or the funding market for wealth-management products; the imposition of trade barriers by trading partners; or a return of capital outflow pressures because of a faster-than-expected normalisation of US interest rates.

The political dimension to this, unaddressed by the IMF, not surprisingly given its sensitivity, is whether President Xi Jinping will emerge from next week’s Party Congress in a sufficiently strong position to be able deemphasize near-term growth targets and implement more reforms that would enhance the sustainability of growth. Without doing so, he will be unable achieve his long-term goal of maintaining the Party’s monopoly grip on power while transforming China’s economy to its next phase of development.

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VAT And China’s Other Taxing Problems

CHINA STARTED TO replace its Business Tax with a value-added tax (VAT) in 2012 when a pilot scheme was launched in Shanghai. VAT has since been steadily expanded, both geographically and sectorally.

Earlier this month, following an executive meeting of the State Council, chaired by Prime Minister Li Keqiang, plans were announced for streamlining the administration of VAT and acknowledging that it has become a universal national tax.

The service sector first saw the tax in May last year when it was applied to property, financial and consumer services sectors. At the same time, VAT was extended fully nationwide.

Authorities say that between then and June, the switch to VAT has saved businesses 85 billion yuan ($12.8 billion) in taxes, providing an important boost to the ‘rebalancing’ of the economy towards consumption. Total tax savings since the pilot scheme started is put at 1.6 trillion yuan.

In July, the four VAT brackets (17%, 13%, 11% and 6%) were reduced to three with the elimination of the 13% bracket. Agricultural products, tap water, publications and several other ‘13%’ goods were moved down to the 11% bracket, though that still leaves more VAT tiers than the international average.

The new plans foresee digitization of the tax system, simplifying procedures for tax filing and switching from physical to electronic versions of the invoices-cum-receipts (fapiao) that serve as legal proof of purchase for goods and services. Fapiao are a key component of enforced compliance with China’s tax law as they compel companies to pay tax in advance on future sales.

The VAT fapiao is also used for tax deduction purposes within VAT, so digitising the whole process should streamline the accounting.

The tax is still referred to as “the VAT reform pilot program” though that status as a pilot looks like ending de jure as well as de facto; the State Council executive meeting also indicated that more detailed national VAT legislation would be forthcoming.

There is more work to be done on standardising it as a national tax. There are still inconsistencies between sectors in the rates applied to the same goods and services. Also, some tax payers are not able to make full VAT deductions. A further issue to address is compliance costs for taxpayers with multiple business locations.

One major issue that a national VAT does not address is how the tax take is shared at the provincial level. (Germany and Japan, for example, use allocation rules based on population and aggregate consumption, respectively.)

However, China has a bigger problem of fiscal redistribution to tackle. The country has the largest share of local government spending in the world, largely because public services and the social safety net (health, education, welfare, etc.) are centrally mandated but delivered and paid for at the local level. Many federal countries decentralise their social insurance system, but China is a rarity in having both its public pension system and unemployment insurance managed at the local level.

Yet, since the fiscal reforms of 1994, provinces and municipalities have negligible revenue raising powers of their own. Further, although 60% of taxes are collected by local government, those taxes are handed over to central government with some to be returned via revenue-sharing and other transfer schemes through rules that are still not completely transparent.

Transfers from the central government were supposed fully to finance local-government deficits since provinces and municipalities were barred from issuing debt.  In practice, however, local governments were given increasingly large unfunded mandates. Because of the prohibition on issuing debt, they resorted to selling land and using off-budget special-purpose vehicles to borrow and spend on infrastructure, starting the infamous local-government debt bomb ticking.

Local governments debt had reached the equivalent of around 40% of GDP by 2015.

A fiscal reform plan was announced in 2016 to address the misalignment, but it will take a comprehensive imposition of taxes such a market-value-based property tax, local surcharges to personal income tax and maybe even an additional provincial-level VAT — though that is difficult technically to administer; few if any countries have pulled it off.

It will also mean converting the pilot scheme for issuing and trading municipal debt started in 2014 when back door borrowing through special-purpose vehicles was banned, into a national muni-bond market. That, in turn, will require broader financial-system reforms.

Those are proceeding at a cautious, measured pace. Short-term stability and state-centric control is the current leadership’s instinctive approach. That may change after the forthcoming Party congress, but, more likely, it will not. In that context, streamlining VAT to puts greater taxation capacity in Beijing’s hands makes political as well as economic sense.

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China’s ‘Achilles’ Heel’ Of Debt

THE IMF’S LATEST Article 4 consultations report on China’s economy retraces some well-trodden ground. While edging up its projections for China’s growth projections, the Fund again underlines the growing risk from debt in the medium term.

Arguably this is the greatest macroeconomic risk that China faces and which the Fund says needs to be addressed now if sustainable growth is to be sustained. It summarises that risk in a supplementary note to the main report thus:

International experience would suggest that China’s credit growth is on a dangerous trajectory with increasing risks of disruptive adjustment and/or a marked growth slowdown.

Managing the debt issue is inseparable from rebalancing the economy, away from infrastructure investment and export-led growth to domestic consumption.

Progress in rebalancing, the Fund acknowledges, is being made, particularly in reducing industrial overcapacity. Borrowing by local governments is being made more transparent, and regulators have started to address financial sector risks.

The Fund, though, calls, as it has repeatedly done in the past, for the pace of reforms to accelerate, taking advantage of the relatively robust growth the economy is now enjoying.

Its check list of five action points will be familiar:

  • boost consumption by increasing social spending by the government and making the tax system more progressive;
  • increase the role of market forces by reducing implicit subsidies to state owned enterprises and opening up more to the private and foreign sectors;
  • deleverage the private sector by continuing the recent regulatory tightening in the financial sector and greater recognition of bad assets in the financial sector;
  • ensure macroeconomic sustainability by focusing more on the quality of growth and less on quantitative targets; and
  • improve policy frameworks so that the economy can be better managed.

The fund particularly recommends accelerating the reform of state owned enterprises by moving social functions away from them and opening their protected sectors to more private and foreign competition.

There will be a cost to that which will strain the financial system. Bankruptcies will rise with the elimination of blanket state guarantees and lenders that have made uncreditworthy loans will get into trouble. The political concern is that strain on the financial system turns into social stress.

IMF China reforms scorecard August 2017

As this Bystander has noted before, policymakers have been steadily if cautiously managing down the GDP growth rate for several years, mostly by reducing too high investment and too rapid credit growth. They have been less active in opening up replacement sources of growth, notably by opening up to the private sector.

The fund also lays great importance on the need to liberate private savings for consumption by increasing public spending on health, pensions and education, three areas in which its spending is well below the OECD average, and by increasing social transfers to the poor, who are disproportionately greater savers than the poor in other countries,

Again as this Bystander and many others have noted before, the longer China delays tackling the structural underpinning of its debt load, the longer resolving them will take and the greater the risk of not doing so becomes.

This is an opportune moment from an economic point of view to do so. Growth in the first half of the year was more robust than expected with both the global economy and financial conditions being benign. Domestically, the effects of cutting industrial capacity are starting to work through, bolstering profits and areas of the private sector where state-owned enterprises are largely absent, such as e-commerce are showing exemplary dynamism.

Also, balance-of-payments and exchange-rate management have been adept while some old-school fiscal stimulus six to nine months ago has also kicked in.

Markus Rodlauer, deputy director of the IMF’s Asia and Pacific Department, put it this way:

The situation at this point right now…should be used as an opportunity…to bear down and to buckle down and continue with this financial sector adjustment, which is really the Achilles’ heel now of the economy.

Once the 19th Party Congress due to be held in October or November is out of the way, and assuming it has not changed politics appreciably, that may happen more visibly.

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IMF Sees Increases In China’s Growth And Debt

THE INTERNATIONAL MONETARY Fund (IMF) has upgraded both its economic growth forecast for China in 2018 and the downside risks of debt.

In its July update to its World Economic Outlook, the Fund says its projections reflect the strong first quarter growth this year and expectations of continued fiscal support.

It now says it expects growth next year to be 6.7%, the same as this year and in 2016, and 0.1 percentage point higher than previously forecast. Growth in 2018 is expected to slow by 0.2 percentage points less than previously projected, to 6.4%.

This the Fund believes will be because authorities will sustain high public investment to achieve the target of doubling in real terms 2010’s GDP by 2020. This, in turn, implies that debt levels will not be attacked as actively as needed and financial reforms delayed.

The National Financial Work Conference, the high level policymaking agency chaired by President Xi Jinping that concluded its quinquennial meeting on July 15, emphasized that policymakers’ priority was to deleverage state-owned enterprises (SOEs) within its focus on limiting systemic financial risk.

First, though, Xi has to get through the forthcoming Party plenum, which should provide clues to the strength of his position to tackle the politically powerful interests that control the SOEs.

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