• Tackle credit bubble or let growth decelerate?


    In the aftermath of the financial crisis, central banks around the world adopted an easy-money regime to prop up growth. China’s central bank, the People’s Bank of China (PBoC), was no exception. Not only did bank credit growth explode in a very short period, other avenues of credit creation also multiplied quickly. China’s overall stock of credit to gross domestic product (GDP) has crossed 200%.

    That naturally raised concerns over the health of the banking sector. Surprisingly, the level of non-performing loans has remained low, at 1.1% of GDP last year, although it is widely believed that this figure does not reflect the true extent of bad debts because of restructuring.

    Risks are heightened by the fact that not all this credit creation happened through formal bank loans. Off-balance-sheet credit by banks increased, as did lending by other institutions such as trust companies and non-banking fi-nancial companies. Termed shadow banking, these constitute around 35% of China’s economic output.

    Many of these trust and non-banking companies are not fully regulated and lack safety nets. China’s own policies have fuelled the rise of such shadow banking. It capped the interest on bank deposits but allowed wealth man-agement schemes run by banks to offer higher rates than deposits, tying their returns to loans created against products. These schemes became mostly off-balance-sheet items for banks.

    Much of this shadow banking credit has flown into riskier sectors such as local government infrastructure and real estate. Banks themselves were discouraged from lending to such sectors.

    That said, there is some buffer in case it all falls down. According to available data, the quantum of outstanding shadow banking credit is estimated to be around 23 trillion yuan. This is roughly equivalent to the amount of re-serves held by the PBoC in the form of deposits from banks.

    Still, many advanced economies have much larger shadow banking sectors. A 2014 report from the Financial Stabil-ity Board puts the size of the shadow banking sector in the Netherlands at 760% of GDP, the UK at 348%, Switzer-land at 261% and the US at around 150%. China’s global share of the shadow banking sector, though, has grown relatively fast from 1% in 2007 to 4% in 2013.

    The real concern, is the lack of clarity over the true size of shadow banking in China; this is typically likely to be un-derestimated.

    Owing to the explosion in lending, China’s overall debt-to-GDP ratio (note that this also includes debt owed by fi-nancial institutions) ballooned to 282% in 2014. Although this is largely comparable to other major economies, what stands out is the high amount of debt owed by the non-financial corporate sector. That is a natural corollary of the state-promoted stimulus package of 2008-09, which encouraged public sector firms to borrow and invest. This has also led to concerns over the worsening balance sheets of these companies.

    While China’s government debt at 55% of GDP doesn’t raise too many eyebrows, the real concern is the fiscal health of local governments, which have poured money into real estate and infrastructure projects. The decline in home prices since 2013 has eroded the value of such assets. More worryingly, a 2014 national audit report pointed out that local governments often resorted to selling land to pay off maturing debts, evidently an unhealthy and unsustainable practice.

    With local government debt burden at 17.9 trillion yuan (around 30% of GDP), the central government has imposed caps on additional debt and extended swap facilities which can help reduce interest costs.

    While the PBoC (and other regulators) increased scrutiny of lending practices, it also has to face up to the challenge of slowing economic growth. This forced the central bank to relax reserve requirements and cut interest rates five times since November last year.

    The dilemma also means monetary and regulatory policies often appear inconsistent.

    For instance, in the face of a credit bubble, the government has now proposed removing the ceiling on the lend-ing-to-deposit ratio, currently at 75%.

    The PBoC is reportedly providing funds to various state lenders (termed policy banks), which in turn use the mon-ey to finance government-backed schemes. This is liable to create another round of debt-fuelled investment spending, though the authorities seem to be aiming to direct the flow of credit to only specific sectors, especially high-tech manufacturing.

    Another example is the housing sector, where the bulk of the local government debt has gone. In March 2013, the government increased restrictions on the property sector to tackle concerns of rising house prices and a potential bubble. Measures included an increase in required down payment, an increase in mortgage rates on second home purchases, capital gains tax on profit made in the property market and some property tax. Many of these have been reversed or eased, which might again induce speculative activity, especially after recent interest-rate cuts.



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