IMF: China’s credit growth is unsustainableVW Staff
Rebalacing In China: Analytics And Prospects by IMF so says the headline at Reuters. The IMF is not the first to be bearish on China nor will they be the last. See Reuters for a nice summary of the report. Also see the bear case below and an impressive bull case from one of the best China analysts.
- China is transitioning to a more consumer and service-based economy. This paper reviews progress along various dimensions of rebalancing and presents staff projections for the medium-term rebalancing path.
- External rebalancing has advanced well, while progress on internal rebalancing has been mixed—substantial on the supply side, moderate on the demand side, and limited on credit dependence. Rebalancing on the environment and inclusiveness has lagged.
- Going forward, the high national saving is expected to fall owing to demographic change and a stronger social safety net. The consumption ratio is expected to increase with rising labor income share and falling household savings. The investment ratio is forecast to fall in line with national saving, with external balance becoming more entrenched.
- Supply side rebalancing from industry to services is expected to advance further, helping reduce carbon intensity of output and promote income equality. Credit rebalancing is likely to progress slowly unless decisive corporate restructuring and SOE reforms are implemented.
A. Definition of Rebalancing
1. Rebalancing in China contains four important elements: external, internal, environmental, and distributional. While external rebalancing focuses on the role of external demand versus domestic demand, internal rebalancing has a much richer content: shifting from investment to consumption on the demand side, transitioning from industry to services on the supply side, reducing credit intensity of output, and improving the efficiency of resource allocation. They are closely interlinked and often reinforce each other. Environmental rebalancing aims to reduce the carbon intensity of output and make growth more environment-friendly. Income distribution rebalancing aims to create a more equal society by increasing the share of labor income in GDP and reducing income inequality.
B. Progress on Rebalancing
2. External rebalancing has advanced well, but at the cost of growing internal demand imbalances until 2011. After the Global Financial Crisis, substantial progress has been made on external rebalancing. China’s current account surplus has come down from the peak of 10 percent of GDP in 2007 to around 2–3 percent in recent years, and the contribution of net exports to growth has been fluctuating around zero (from 2 percentage points of GDP annually in the pre-GFC peak).
Nonetheless, the narrower external imbalance has come at the cost of growing internal imbalances, with the investment ratio surging to 45 percent of GDP by 2011 (from about 38 percent in the pre-GFC years).
3. Progress on internal rebalancing has been moderate on the demand side… Since 2012, demand side rebalancing from investment to consumption has advanced, with a notable acceleration in 2015 and 2016:Q1 (consumption contributing two thirds of overall growth). Nonetheless, China remains a global outlier in its demand structure, with its investment ratio elevated at 43 percent of GDP, while private consumption accounts for only 38 percent of GDP.
4. …while lagging on the credit side. High investment, together with credit misallocation, has led to falling efficiency: the credit intensity of output doubled compared to the pre-GFC period and has continued to rise. Credit misallocation has, to a large extent, been driven by financing of nonviable firms, especially state-owned firms in overcapacity sectors, such as construction and steel. Since 2016, there have been early signs of improving credit structure, with a shift of lending from overcapacity sectors to the “new economy,” but overall credit misallocation remains significant.
5. Supply side rebalancing has, however, made more substantial progress. Similar to the experience of other advanced economies, China started to de-industrialize at an income level of about US$9,000 (in 1990 international prices), with the output share of the industrial sector peaking in 2011. Since 2012, the nominal share of industry has been on a steady decline, and the pace of decline has been similar to the historical experience of advanced economies. The falling nominal share reflects to a large extent the price effect so far, as the decline in the real share has been much more muted. This is also in line with international experience, as relative price change is an essential part of deindustrialization, especially at the beginning. Resource reallocation will typically accelerate after these price movements. Another indicator for real adjustment is the industrial employment share, which peaked in 2012 and has been on a steady decline since then.
6. Rebalancing on environment and inequality are lagging. Some progress has been made in reducing the energy and carbon emission intensity of GDP, however, PM 2.5 indexes (fine particle air pollution) in cities remains very high. Rapid growth has been accompanied by growing income inequality, with the Gini index2 rising from 0.3 in the 1980s to 0.53 in 2013. Progress has been made in recent years, with labor income gaining a larger share in GDP, but the redistributive role of fiscal policy remains limited as shown in the small difference between gross and net Gini index.
C. Prospects for Rebalancing
Staff’s baseline envisages substantial progress in pro-consumption and services reform, but a lack of decisive SOE reforms and slow progress on hardening budget constraints. This will give rise to continued internal rebalancing on the demand and supply side, but less on credit side. The improvement in external balancing is likely to continue.
7. The household saving rate is projected to fall, reflecting demographic changes and pro-consumption reforms. China will experience rapid ageing in the next 15 years, with the oldage dependence ratio forecast to double from its current level by 2030. Cross-country evidence suggests such demographic change would significantly reduce the saving rate. In addition, precautionary saving is expected to fall with the strengthening of the social safety net, achieved through higher government spending on health care (rising from current 1.5 percent of GDP to 2.1 percent by 2021). As a result, household saving is expected to fall from 24 to about 20½ percent of GDP by 2021. Recently, the government has lifted the one-child policy, which may induce the saving rate to fall faster than staff projections, depending on the effect on the fertility rate.
8. The investment ratio is expected to fall broadly in line with national saving, with external rebalancing becoming more entrenched. Gross fixed asset formation in GDP is projected to fall gradually to 40 percent of GDP by 2021. The fall in investment will reflect both moderating private investment, as returns diminish in a slowing economy, and less excess in public investment. With the commensurate fall in investment and national saving, the current account surplus is projected to remain low, and decline further to less than 1 percent of GDP in the medium term.
9. Consumption’s share of GDP is expected to increase with rising labor income share and falling household savings. Private consumption’s share of GDP is projected to rise from around 38 percent in 2015 to 43 percent in 2021. The increase will come from rising labor income share in GDP (linked to the transition from industry to relatively more labor-intensive services) as well as declining household saving out of disposable income.
10. Credit intensity, although expected to fall, will remain high in the medium term; as a result, the private debt-to-GDP ratio continues to rise. Credit intensity is forecast to fall modestly, owing to lower investment ratio and some improvement in efficiency, but remains high in the medium term, reflecting moderate SOE reforms and slow progress in hardening budget constraints and loan write-offs. By 2021, the private credit to GDP ratio (excluding LGFVs) is expected to approach 200 percent, up from about 160 percent in 2015.
11. Services will become a more important pillar of the economy. The nominal share of services in GDP is projected to rise from current 50 percent to 55 percent by 2021. This will be achieved through both a price effect (higher service deflator than industrial deflator, reflecting the productivity growth differential) and in real terms and employment. By 2021, the share of service employment is forecast to rise to 51 percent, continuing the trend of net job creation in services seen in recent years.
12. The changing economic structure will facilitate enviromental and income distribution rebalancing, but proactive, supporting policies are also needed. While the changing economic structure will naturally bring down the carbon intensity of GDP, China still needs more proactive policy measures, such as a carbon or coal tax, to reach the target set at the 2015 Paris climate summit. Similarly, a more service-oriented economy will give rise to a higher share of labor income in GDP, but requires further service sector deregulation to facilitate entry of new firms and job creation. A more redistributive fiscal policy will also be necessary to bring down income inequality, and provide more equal opportunities to both urban and rural households.
13. Successful rebalancing requires coordinated progress on various fronts. Going too fast in one area and slow in others may derail the process, in particular: (1) asynchronous adjustment in savings and investment (rapid decline in investment with still high savings will simply shift China’s imbalance abroad, while continued excessive investment despite falling saving would eventually lead to dependence on foreign financing and greater exposure to global financial volatility); (2) premature deindustrialization (de-industrializing too fast may lead to a significant growth slowdown and stall income convergence); (3) continued debt overhang (lack of progress on credit rebalancing would significantly raise the probability of a disruptive adjustment, especially when buffers to absorb financial shocks erode with lower national savings over time).
China: Shifting To A Modern, Market-Based Monetary Policy Framework
- Financial liberalization and greater exchange rate flexibility require a modern, market-based monetary policy framework focused on maintaining price stability.
- The full liberalization of bank lending and deposit rates was an important milestone in the process of shifting to a market-based system.
- Interest rate policies now play a substantive role in the determination of both real activity and inflation and increasingly contain information about the monetary policy stance.
- The next major reform should be the introduction of an inflation target or a range together with operational (instrument) independence for the People’s Bank of China (PBC).
- Effective communication of the PBC’s policy stance and economic outlook, as well as further analytical capacity, is essential for the effectiveness of inflation targeting.
1. China’s rapid transformation into a service-oriented, market-based economy with greater exchange rate flexibility requires a modern monetary policy framework. The government has implemented a host of financial market liberalization measures including in the banking sector (liberalization of bank lending and deposit rates, for example), and stock and bond markets, and remains committed to further reform. This is welcome. But heightened financial market volatility (with global spillovers) in the wake of several changes in exchange rate policy and rapid credit growth point to the need of taking into account the growing linkages between monetary policy, financial stability and the exchange rate regime as financial markets are liberalized and capital flow restrictions gradually eased.
2. With greater exchange rate flexibility, monetary policy will need to focus increasingly on domestic price stability. The exchange rate has long been a nominal anchor for China’s monetary policy and the renminbi was pegged against the U.S. dollar until 2005. Subsequently, the renminbi appreciated steadily. But since early 2014 capital outflows accelerated and the currency depreciated against the U.S. dollar as the PBC made several adjustments to the exchange rate regime with a view to allowing more flexibility in both directions. In recent communications, the authorities highlighted greater reference to a currency basket rather than the U.S. dollar. Naturally, these changes have led to rising uncertainty and volatility of exchange rate expectations, implying the need for a new nominal anchor for China’s monetary policy which, as in most other countries, could be domestic price stability and, preferably, an explicit inflation objective. An effective float remains the goal, ideally by 2018, and should be adopted once the shift to a market-based, flexible inflation targeting approach is achieved.
3. China’s monetary policy framework is in the midst of transitioning to a market-based approach. Historically, the PBC has employed a number of tools (price- and quantity-based) to conduct monetary policy. However, its operational conduct is increasingly relying on a standard interest-based system and short-term market interest rates increasingly contain information about the monetary policy stance. Although money growth (M2) remains the official intermediate target (now at 13 percent y/y for 2016), the PBC has recently de-emphasized its importance, which paves the way to a money market rate as the intermediate target. Short-term repo rates have become much less volatile after the PBC introduced reserve averaging for banks and appears to calibrate the liquidity impact of its various policy measures to ensure that money market rates move closely with its own benchmark rates.
4. The seven-day interbank repo rate appears to have become the targeted short-term money market rate. Over the past few quarters, this rate has consistently traded just above the PBC’s reverse repo rate, which banks have to pay for PBC funds with maturity of one week. On October 26, the PBC cut its seven-day reverse repo rate by 10 bps to 2.25 percent and since then the seven-day interbank repo rate fixing—a daily trade-volume weighted average—has traded closely above this rate, averaging 2.38 percent. This implies that the PBC largely accommodates banks’ liquidity demand at the “policy” reverse repo rate. At the beginning of this year, the PBC increased the frequency of its open market operations from bi-weekly to daily.
5. The corridor around the seven-day repo rate is likely to be defined by the interest rate on excess reserves (lower bound) and the standing lending facility (upper bound). Together with its open market operations (OMOs), the PBC also operates several standing lending facilities with various maturities. The standing lending facility (SLF) offers overnight (currently at 2.75 percent), seven-day (currently at 3.25 percent), and one-month (currently at 3.6 percent) liquidity to domestic banks and other local financial institutions. The PBC is exploring the use of the seven-day SLF to set the upper limit of an interest rate corridor. The interest rate that banks receive on their excess reserves deposited at the PBC (currently at 0.72 percent) sets the lower bound of the interest rate corridor.
6. The PBC’s other longer-term lending facilities complement the daily open market operations and provide longer-term funding mainly for national priority projects. The PBC also operates a number of medium-term lending facilities (3-month, 6-month, 1-year maturities) but access to these facilities is mostly granted to a number of large banks and the amount available is preset. With these facilities, the PBC aims to guide market interest rates at longer tenors but often these tools are also employed to support other policy objectives, such as lending to small- and medium-term enterprises. The pledged supplemental lending facility (PSL) provides funds with one-year maturity to policy banks to finance urban upgrades.
7. The PBC requires banks to post central government bonds, central bank bills or policy bank bonds as collateral for its open market operations. Local government bonds do not currently qualify as collateral but the PBC is reportedly exploring the possibility of adding these to the eligible pool of assets for OMOs. Other liquidity operations may each have their own collateral requirements but there is limited transparency on the specifics.
8. Reserve requirements continue to play a role in the PBC’s liquidity management but do not seem to be an independent signal of the policy stance. The PBC has traditionally adjusted reserve requirements to help with the sterilization of large liquidity injections and withdrawals related to its intervention in the foreign exchange markets. The rate on reserve requirements peaked in 2011 (at 21 percent for large banks) and has since been lowered to 16.5 percent to partly compensate for the liquidity withdrawn by the PBC through its FX sales. The latest cut in March, however, had virtually no impact on money market conditions with other PBC liquidity operations calibrated to keep the seven-day repo rate closely above the PBC’s 2.25 percent reverse repo rate.
9. The full liberalization of bank lending and deposit rates was an important milestone in the process of shifting to a market-based system. Variation of lending rates across banks has increased and about 40 percent of bank loans are now priced more than 10 percent above the benchmark rate, which signals that a larger pool of customers may now have access to bank credit. This should facilitate a better allocation of credit and transmission of monetary policy. Although banks appear reluctant to engage in greater competition for retail deposits, many banks offer their retail clients principal guaranteed wealth management products mainly invested in short-term money market instruments or government paper and competition for these, as well as deposit certificates (CDs) and other wholesale funding tools, is more pronounced. To enhance commercial banks’ response to the policy rate and money market conditions, the PBC should reduce or eliminate the administrative tools used to influence banks’ activities such as setting credit targets through “window guidance” for individual banks, unless these are for the purposes of macroprudential policy.
10. The recent growth and importance of bond, repo financing and other market-based financing tools also imply a stronger transmission of the interest-based policy stance than in the past. Over the past few years, corporate bond issuance and repo financing have surged and the use of other financing tools (trust and wealth management products etc.) has grown rapidly. The cuts in PBC interest rates have been reflected in money market rates and have also reduced corporate financing costs in the bond market. Since early 2014, the reductions in the PBC’s refinancing rate have been more or less fully passed on to short-term (2-year) government paper and the yield for highly-rated corporate bonds. While the prevalence of implicit state guarantees prevents the appropriate (usually countercyclical) pricing of credit risk in the bond market and distorts credit allocation, it makes the transmission of the policy stance to market rates even stronger due to the lack of countercyclical risk premiums.
11. Inflation and growth are clearly correlated, although the impact of the output gap on inflation appears limited. This might reflect uncertainty and potentially large measurement error for China’s output gap (and inflation). Moreover, many prices especially in the service sector remain regulated or administered. Global factors, such as international commodity prices and global activity appear to be important drivers of nonfood inflation in addition to the part that is imported U.S. inflation adjusted for exchange rate changes. Porter (2010) finds that cost pressures—reflected in domestic and foreign input prices—and expected inflation play an important role in explaining producer and nonfood consumer inflation. While direct domestic demand pressures have little impact on overall nonfood inflation, foreign demand pressures (as measured by the foreign output gap) play a substantial role.
12. Nevertheless, the monetary transmission mechanism in China is becoming more similar to that in the United States and other major market economies. Fernald, Spiegel, and Swanson (2014) find that changes in Chinese interest rates have a substantial impact on economic activity and inflation, while other measures of changes in credit conditions, such as shocks to M2 or lending levels do not once other policy variables are taken into account. They use a broad set of Chinese economic indicators and a dynamic factor model framework to estimate Chinese economic activity and inflation as latent variables in a factor-augmented vector autoregression (FAVAR) to estimate the effects of Chinese monetary policy on the Chinese economy. Their approach is particularly well-suited to such analysis due to concerns about Chinese data quality, a lack of a long history for many series, and the rapid institutional and structural changes that China has undergone. As more data under the new regime of liberalized financial markets and interest rates become available, it should become easier to identify and estimate the effect of changes in the policy interest rate on activity and inflation.
13. To complete the transition towards a more market-based framework, the key next steps for the authorities to consider include:
- Objectives: Although the PBC does not operate under an explicit inflation targeting regime its official mandate is “maintain the stability of the currency value and thereby promote economic growth”. This is similar to that of other central banks with a focus on price stability and the next step should be the introduction of an explicit medium-term inflation target or a range (set by the government/state council) together with operational (instrument) independence for the PBC.
- Instrument: The PBC should declare the seven-day repo rate its new intermediate policy target for monetary policy purposes, permit more flexible use of reserves averaging and publish a new market rate (7-day repo) representative of lending conditions for Tier 1 banks only. Longer-term rates should be market-determined, reflecting expectations of the central bank’s future policy rates, future inflation, among other factors. The clearer the policy framework, the easier it will be for the market to establish a yield curve. Standing facilities should act as a backstop with unlimited access for banks on demand against appropriate high-quality collateral. Eligibility and collateral requirements for the PBC’s liquidity facilities should be clear and transparent.
- Communication of the PBC’s policy stance and economic outlook would increase the effectiveness of a flexible inflation targeting framework. Historically, many central banks kept markets guessing, to some extent, about their policy intentions; but most central banks have found that policy operates more efficiently and effectively if (i) the policy is clearly and simply communicated; and (ii) implementation fully supports the stated policy. Simultaneous publication of monetary policy reports (at least the conjunctural chapter) in English would support these goals.
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