China’s plan to cut debt, ensure efficient capital may be mission impossible in a slower economy
Liu He’s appointment to head task force bodes well for China’s attempt to reform the nation’s state-owned enterprises
China must improve the efficiency in the way capital is allocated across the economy, according to a recommendation by the International Monetary Fund (IMF). The success of that plan will depend on the government’s ability to cut debt and reform the country’s state-owned enterprises.
Credit growth has “slowed significantly” in China since 2017 as China’s top-down deleveraging campaign has crippled shadow bank lending and curbed traditional borrowing, the IMF said in its Article IV review of the Chinese economy released last week.
Under the IMF staff’s baseline case, China’s credit intensity ratio (the amount of credit necessary to generate each incremental amount of economic growth) is expected to improve from 3.1 in 2017 to 2.6 in 2023.
“That improvement, however, will not be enough to stabilise the credit-to-GDP ratio,” the IMF report warned.
China can finally stabilise the ratio of total debt to the size of the economy by the year of 2020, and see it fall thereafter, if it can significantly improve credit efficiency by increasing the allocation of credit to the nation’s most profitable corporations.
But SOEs represent the biggest hurdle to achieving this goal.
“China’s credit efficiency has been hindered by deteriorating corporate (particularly SOE) productivity and inefficiency of credit allocation – a financial system problem given bank dominance” in credit provision, Aidan Yao, senior emerging Asia economist at AXA Investment Managers, told the South China Morning Post in a written response to questions.
To reverse the deteriorating trend in credit efficiency, Beijing needs to tackle its causes.
“Here, the hope is that the recent appointment of Liu He (to spearhead the SOE reform effort) will help to speed up the process by bringing to the task more hands-on experience in reform as well as political authority in decision-making.”
Last week, Liu He, China’s point man in trade negotiations with the US and President Xi Jinping’s strong ally, was appointed as the new head of the SOE reform task force under the State Council.
Liu will lead a team of 15 senior officials from a number of ministries – including the central bank and China’s securities, banking and insurance regulators – as Beijing focuses more attention on reform of domestic structural problems in the absence of any immediate prospect for a negotiated trade settlement with the US.
While SOEs remain significantly less profitable than private firms and carry much more debt, since 2015 the share of loss-making SOEs has declined from 28 per cent to 24 per cent, the ratio of their liabilities to profits has improved, as did their return on assets, the IMF report acknowledged.
At the quarterly meeting of the Politburo held on Tuesday, China’s top decision-making body gave conflicting instructions on economic policy priorities for the second half of the year. While ordering a clear shift to more stimulative fiscal and monetary policies, it also emphasised the need to continue the deleveraging programme.
The reason behind the shift in attitude is simple. China’s economy is already showing signs of slowing, with growth easing to 6.7 per cent in the second quarter, with the effects of the US tariffs on exports expected to add to downward pressures on growth caused by the tighter credit environment.
However, given the low efficiency of credit issued to SOEs, analysts worry additional borrowing will simply worsen China’s debt problem, reversing the efforts to rein in credit made since late last year.
The growth solution works only if most new credit goes to more efficient private firms.
“If all the fresh credit goes to the best-performing firms – usually private firms, rather than state-owned firms – plus the latter cut debt at a speed faster than the new leverage being created by the former, easing will not affect deleveraging,” said Iris Pang, ING Greater China economist.
However, banks continue to prioritise lending to SOEs, in part for political reasons, in part for the implicit government guarantee of repayment.
Failure to shift this practice could cause the new stimulus programme to backfire, analysts warn.
“My biggest concern is if the trade war escalates further, forcing private exporters to start laying off people, the SOEs will be asked to take on the laid-off (employees) as part of their social responsibilities, making reform even more difficult,” Pang added.
China’s deleveraging campaign is halfway completed. Total Social Financing (TSL), a broad measure of credit and liquidity in the economy, grew by 9.1 trillion yuan (US$1.3 trillion) during the first six months this year, 2.03 trillion yuan less than growth in same period in 2017, official data shows.
But a series of easing signals sent by authorities in the past two weeks are blurring the outlook.
Last Monday, the State Council announced the country would adopt a more active fiscal policy to support the economy and tackle uncertainties arising from the worsening trade conflict with the US, essentially indicating government would once again boost spending on infrastructure.
A week ago, People’s Daily published an article announcing China would shift to “stabilising leverage” from “cutting leverage” after “an initial success” was achieved in the first half. This indicated that credit would be loosened in the period ahead and, in the following days, commercial banks nationwide said the central bank had eased their capital requirements, meaning they would have more money to lend.
A loosening of credit conditions, by itself, does not threaten the government’s deleveraging goals. The key is how well the credit is allocated.
“In fact, if you look back at the most orderly deleveraging processes carried out by some economies, you will see monetary conditions were rarely kept too tight,” said AXA’s Yao.
If you tighten liquidity conditions too quickly, economic growth may contract faster than debt. On the other hand, if the additional liquidity is allocated well, the growth of the economy could outpace that of debt, resulting in what [Bridgewater hedge fund head] Ray Dalio has called a ‘beautiful deleveraging,’” Yao added.
But the shift to more stimulative policies raises questions about whether China is falling back into the bad habit of bolstering growth through an accumulation of yet more debt.
“The set of recently announced measures to ease fiscal and monetary policy conditions in the face of a growth slowdown suggests that the trade-offs between deleveraging and growth are becoming more stark,” said Gene Fang, an analyst at Sovereign Risk Group of Moody’s.
However, with the policy emphasis shifting back to sustaining GDP growth, the risk is rising that there will be a “further build-up of government debt and contingent liabilities over the longer term”.
“These measures will result in slightly higher government debt, and a slower decline or potentially a pickup in the credit intensity of growth,” though immediate credit implications are limited, he said.