Wanted: reforms in China ... before it gets too late
China’s policymakers may find 2016 just as challenging as the year just ended, judging by the findings of an International Monetary Fund (IMF) Working Paper published on December 28 which argues Beijing needs to seize the moment and initiate additional financial sector reforms.
The working paper’s key finding is that the steps taken so far by China, although important, are insufficient and that “progress in removing implicit state guarantees” has not proceeded as quickly as other reforms.
“Financial sector reforms in China are progressing at an uneven pace,” it stated, arguing that “with implicit state guarantees still in place, [China’s] banks have little incentives to seek better projects and correctly price risk.”
“Implicit guarantees are widespread in China” and “a number of firms (the borrowers) enjoy privileged access to credit as creditors presume that they are implicitly supported by the government,” it noted.
With state-owned enterprises (SOEs) the main, but “not exclusively the only beneficiaries of these guarantees,” the IMF-authorised paper believes “removing implicit guarantees is [the] key to more efficient growth”.
But it also notes that such reform is difficult given the “the powerful lobby of SOEs” and “concerns about social stability”.
As a consequence, China’s “economic efficiency suffers, preserving a system too dependent on debt and investment as an engine of growth”.
However, the paper’s authors do admit that “while permitting more defaults is necessary, it may have negative repercussions for the stability of the financial system [that is] unaccustomed to risks”.
While “the views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management,” the papers are authorised for distribution under the Fund’s mantle and so carry weight.
To be fair, policymakers in China have shown an understanding of the need to implement financial reform.
With 2015 having already seen the Chinese banking industry registering its highest level of non-performing loans since the beginning of the global financial crisis, it is clear some prior lending decisions by China’s banks have resulted in a misallocation of resources.
In this vein, there has already been an attempt to address the thorny issue of loans made by China’s banks to local governments.
Having already been obliged in 2015 to swap higher-yielding loans for 3.2 trillion yuan worth of low-yielding local government bonds, China’s banks can expect to have to participate in similar schemes in the next few years.
Finance Minister Lou Jiwei spoke favourably of the bonds-for-loans swap on December 22 while also noting a worsening in local governments’ abilities to repay their debt as it is currently configured.
Though some might argue that such a swap scheme merely pushes the problem down the road, at the very least it reflects an official admission that there is an issue and that is itself a step in the right direction.
Yet, while there is never an easy time to implement financial sector reforms, the necessity to do so will almost always occur at an inopportune moment when the costs of a prior misallocation of resources mount.
With China’s economy adjusting to its new normal of a somewhat lower pace of economic expansion, and with the yuan having weakened over 2015 in large part as a consequence of capital outflows, initiating financial sector reforms now may be necessary but the political decision is not easy.
Policymakers have to be prepared to accept there might be short-term economic pain in order to ensure long-term gains for the economy. Any New Year resolutions to implement reforms will need a resolute approach.
Of course, an increase in central government spending, though entailing an expansion of China’s budget deficit, could both alleviate short-term downsides to the economy caused by further financial sector reforms and hopefully smooth the country’s glide path into a slower pace of growth.
Either way, as the IMF working paper points out, if reforms in China are not implemented soon, the obstacles to reform will only rise “as liberalising other parts of the financial system without the removal of implicit guarantees will increase the overreliance on credit and lead to more risk taking.”
China’s “authorities will need to tread carefully to minimize threats to financial stability, but the time to act is now,” concluded the IMF working paper.
It feels time for China’s policymakers to demonstrate some New Year resolution.