On the Necessity and Challenge of Chinese Economic Deleveraging

One of China’s leading economists has weighted in on both the necessity of the country’s current deleveraging efforts as well as the onerous challenges involve.

Li Xunlei, former chief economist for Haitong Securities, has written in a widely circulated opinion piece that China’s financial sector has undergone “excessive” expansion over the past five years, with gross value added now comprising a greater share of GDP in China than the EU, US or Japan.

The Chinese money supply has also witnessed “shocking” expansion in recent years, with domestic banks becoming some of the world’s largest despite a comparatively low level of internationalisation.

According to Li growth in China’s banking and finance sector has also been accompanied by a failure to effectively channel much of the new money created to the real economy.

“Large volumes of money are pointlessly transferred within the financial sector, and it’s highly apparent that the economy has eschewed substance for emptiness,” said Li. “Why is more and more capital concentrated in empty transfers within the financial system, with investors unwilling to place it in the real economy?

“This is obviously related to the lower returns on investment for the real economy – capital always chases profit, and where there is no profit to be had, who would be willing to participate in a transaction?

While data from China’s National Bureau of Statistics indicates that Chinese industrial enterprises posted impressive year-on-year profit growth of 24% for the first four months of the year, returns on investment remain low.

“Because financial sector returns on investment and liquidity levels are far higher than in the real economy, it’s inevitable that capital chasing profits will choose to investment in finance,” writes Li.

Li also points to the existence of implicit government credit backing, leading to higher risk/reward ratios in the financial sector.

An opportune time to deleverage

Given unresolved structural weaknesses in the Chinese economy, Li considers the short-term uptick in economic performance which commenced during the second half of last year to have presented regulators with an opportune window for the government to launch heavy-handed deleveraging measures.

“Financial deleveraging truly began in the second half of last year, with monetary policy gradually tightening and bond yields rising” writes Li.

Chinese regulators have long signalled that a deleveraging initiative would be needed to reduce risk created by the credit boom that Beijing has used to shore up flagging economic momentum since the GFC.

In 2014 the Central Work Committee noted that “from the perspective of the accumulation of economic risk, following the downward adjustment of economic growth various forms of hidden risk have gradually become more apparent…resolving various forms of risk that are characterised by high level and bubble formation will continue for some time.”

According to Li, however, ongoing pressure on China’s economic growth has consistently thwarted government’s efforts to pursue concerted deleveraging measures.

Li notes that unexpected economic upsets have thwarted efforts by the Chinese government to deleverage the economy since the turn of the decade.

When GDP growth held steady at 7.7% in 2013, the Chinese central bank chose to launch a deleveraging initiative targeting the “non-standard” assets of banks in the second half. The severe shortage of capital that ensued compelled the People’s Bank of China to reverse its course half way, however.

China’s shock stock market crash in 2015 similar forced regulators to delay the implementation of heavy deleveraging measures.

The pursuit of deleveraging measures at present nonetheless remains fraught with considerable difficulty and risk, compelling the Chinese regulatory to pursue an extremely difficult balancing act.

Rising interest rates have since greatly reduced Chinese bond financing since the start of 2017, while the poor performance of China’s stock market has also hampered equity financing, making it both difficult and expensive for participants in the real economy to obtain capital.

“Deleveraging and leverage are the same,” writes Li. “Both are double-edged swords: loose monetary policy leads to declining interest rates, declining interest rates are of benefit to raising returns on investment, and also prompt enterprises and consumers to increase leverage, while rising leverage added to systemic financial risk. For this reason we need to deleverage – monetary policy tightens – interest rates rise – investment growth eases – the economy declines.

“For these reasons it’s very difficult to perform financial deleveraging and maintain stable interest rates simultaneously, while also ensuring that economic growth doesn’t come under pressure.”