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IMF To China: Slower Growth Is Here To Stay And Good For You

The International Monetary Fund’s latest World Economic Outlook notes how growth in the leading developing economies, including China, has slowed more than expected. The IMF is now forecasting 7.6% growth this year for China and 7.3% next year, down 0.2 percentage points and 0.4 percentage points respectively from the forecast it made in July. The question is whether this slowdown is cyclical or structural. In China’s case, the Fund says, it is the latter with a cyclical component on top as China comes off a cyclical peak.

What to to about it? First, the Fund says, policymakers have to adjust to lower potential growth, which makes structural reforms to ease the adjustment more urgent. That means rebalancing away from exports and investment toward consumption becomes a priority. “Time is running out on [China’s] current growth model,” the Fund says (though we all sort of know that by now).

As President Xi Jinping has recently signaled, China will grow more slowly over the medium term than in the recent past. No longer can it be taken as a given that stimulus will be the boilerplate policy response to growth falling towards 7.5% — even if it is an instinct that will not be easily kept at bay. That, in turn. will affect may other economies, particularly commodity exporters.

Evidence of this new approach can be seen in the way Beijing is attempting to rein in the flow of credit, including through shadow banks, and opting for targeted support, such as to small businesses, over widespread stimulus. The stimulative expansion of credit in the immediate aftermath of the 2008 global crisis contributed to an investment boom that created massive excess capacity, with capital accumulation running well ahead of domestic demand.

By 2012 investment reached close to 50% of GDP and credit reached almost 200 percent. Deteriorating asset quality, the rat hole of local government’s off-balance sheet spending, and the risk of financial instability are the costs. More balanced growth, the IMF notes, reduces the risk of a hard landing — an event that it has previously estimated could knock 1.5% off global GDP.

A smooth shift to more sustainable, private-consumption-based growth would require, the Fund says,

  • liberalizing interest rates to allow effective pricing of risk;
  • a more transparent, interest-rate-based monetary policy framework;
  • a more flexible exchange rate regime;
  • reforms for better governance and quality of growth;
  • and strengthened financial sector regulation and supervision.

There is nothing novel in that list. The headings could come straight out of Beijing’s current five-year plan, or the World Bank’s playbook, come to that. In short, fiscal and financial reforms are necessary to reduce both public and private saving to free up cash for private consumption, while deregulation of markets and services is need to stimulate productivity growth as the flow of surplus labour from farm to factory exhausts itself. The question is how quickly the leadership can push through the reforms, and how evenly across the board given the varying points of resistance among vested interests that will be disadvantaged by them (more anti-corruption campaigning may be in order to clear the way).

Unlike some of the other large emerging economies, China’s fiscal position is strong enough to absorb reform, though the window is closing. The government can both maintain social and priority spending and address downside contingencies, even if, as the IMF recommends, it should curtail quasifiscal programs, a reference, we suspect, to the temptation to the recapitalization of illiquid and insolvent financial institutions and state-owned enterprises by non-monetary means.

That only leaves Xi with the task of convincing the country’s population, and especially the restive, younger part raised on double-digit growth, that slower growth at the right sustainable pace will actually leave them better off in the long run — something, not uncoincidentally, that would leave the Party better off, too.

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October 9, 2013 · 4:02 am

The Need To Reform China’s Growth Model

Malhar Nabar and Papa N’Diaye are refreshingly plain-spoken in their analysis of China’s growth model and how it must change. They start their new IMF Working Paper, “Enhancing China’s Medium-Term Growth Prospects: The Path to a High-Income Economy,” with the straightforward question, will China successfully transition from a middle- to a high-income economy? It is a critical question, for China and the rest of the world, and one this Bystander has addressed before.

Nabar and N’Diaye’s starting point for their answer is that China’s growth has become too reliant on credit and investment, and that that model has started to experience diminishing returns (see chart below, from their paper). There is a limit to which the economy can grow by relying on capital accumulation and the absorption of surplus rural labour. History suggests that fast growing economies that fail to adapt that model of industrial development ultimately end up in a crisis.

Components of China's GDP growthThe new leadership recognizes that, and has been steadfast in its espousal of the need for economic liberalisation even in the face of a slowing economy on which the global economy is acting as a further drag. But, as the authors acknowledge, not only are certain market, financial and service-sector reforms needed, along with hukou reform, but also their skillful implementation. Not an easy task politically on either score.

The costs of not adapting the growth model are high. The authors estimate that without policy change annual GDP growth could fall to 4% and per capita GDP would stay at one-quarter of the U.S.’s level until 2030. In those circumstances China would fail to scale the Great Wall that separates developing economies that have driven on to become rich countries from those that faltered along the way.

In China’s case, faltering would have dire consequences for the Party’s authority to rule. But by accelerating its reforms, the authors says, China could easily follow the development trajectories of Japan and South Korea.

Convergence of Japan, South Korea and China's per capita GDP with that of the U.S.

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October 4, 2013 · 2:30 pm

Averting China’s Local Government Defaults

The Financial Times‘ estimate that China’s banks rolled over three quarters of the 4 trillion yuan ($642 billion) of local government debt that fell due at the end of 2012 to avert defaults puts a hard number on a soft but growing fear that has been gnawing away at China’s policymakers for some years.

Some history bears retelling. Much of Beijing’s stimulus package in response to the 2008 global financial crisis flowed through local government spending on public works. Local government debt rose by 62% in 2009 over the previous year, as local authorities laded up with bank debt–and the banks, state owned, with potential bad debt. Bank borrowing increased by a further 19% in 2010. By the end of that year, China’s central government debt was a modest looking 17% of GDP. Its local government debt was the equivalent of 27% of GDP.

By February 2011, the China Banking Regulatory Commission (CBRC) was alarmed to discover that more than half of new bank lending wasn’t meeting its new credit rules designed to mitigate the build-up of potentially bad loans. The CBRC’s particular concern was direct and indirect lending to the three top tiers of local government, provincial, municipal and county-level local authorities.

The following month, the finance ministry alerted the National People’s Congress (NPC) that “local governments face debt risks that cannot be overlooked,” though the line was buried deep in a budget report. What concerned officials was the risks involved in the 7.7 trillion yuan of bank loans (as of June 30, 2010) made to local governments’ captive investment vehicles. These local officials were using to get round restrictions on direct borrowing. A finance ministry audit turned up more than 6,000 of them. The audit also found that there was no cash flow to repay 23% of their loans. The suspicion was that by the time the ministry made its report to the NPC the numbers had worsened significantly, intensifying a general concern in Beijing about the overall weakness of local-government governance.

By November 2011, officials were fearful that China’s local government debt had reached 13.7 trillion yen ($2.2 trillion; Italy’s outstanding sovereign debt at the time was $2.6 trillion) including a previously uncounted 3 trillion yuan borrowed by townships, the administrative tier of government below counties. Reforms to local government finance started to be put in place and a rolling 2 trillion-3 trillion yuan bailout deployed to shore up loans backing projects with neither collateral nor viable cash-flow to cover their debt service. Banks were also made to plump up their cushions of capital reserves.

These measures were sufficient to keep the situation manageable through last year. The risk of a local government debt default remained low–as long as economic growth remained brisk and state-owned banks could be made to absorb the worst bad debts. When growth slowed in the middle two quarters of 2012, the banks had to take more of the strain. How much more is delineated by the the Financial Times estimates, as is the challenge China’s local governments face in working down their massive debt loads.

There is one intended and one unintended consequence of all this. Banks have all but stopped extending new loans to local governments. Some authorities have turned to the nascent municipal bond market to raise new debt. But others have turned to the shadow banking system comprising unregulated non-bank financial institutions including trust companies. There have been a series of defaults and near-defaults around these in the past couple of months. None catastrophic. At least not yet. If China’s debt bomb seems to be ticking less loudly, that may just be because it has moved.

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January 29, 2013 · 9:14 pm