There are growing concerns among investors that fast deleveraging and strict regulation will weigh down financial markets.

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China’s economy has yet to enter a new round of steady production expansion, so it mainly relies on macroeconomic policy stimulus and international economic recovery. At the same time, we are seeing constant economic polarization and intensified fluctuations in macroeconomic indicators due to a lack of market-side momentum.

The short-term data fluctuations show that the current round of economic stabilization has entered an inventory replenishment cycle, and some time will be needed before a comprehensive and sustainable endogenous recovery led by supply-side structural reforms can take off. However, the overall downward pressure is under control. In policymaking, though, it is necessary to watch out for excessive financial deleveraging.

 

Potential risks
In the near future, China’s economy needs to contain the following risks:

To start with, since 2017, growth in private fixed-asset investment has rebounded slightly, but the sluggishness in the financial sector has not been fundamentally reversed. Due to stimulus policies under the China Western Development project, western China had the highest fixed-asset investment growth rate in previous years, but it has since dropped below the national average level. This indicates that once policy influence weakened, the market failed to pick up the torch. In terms of overall investment in fixed assets, state-owned enterprises are still the main driving force.

Next, since 2013, the disposable income of China’s urban residents has grown slower than the GDP. Last year, the gap was further enlarged. The relatively slow growth of income will constrain consumption in 2017. At the same time, the widening income gap remains one of the long-term obstacles to expanding production.

Third, the current increase in producer price index (PPI) is mainly the result of rising wholesale prices while consumer goods prices have remained steady for a long time. In production goods, the rate of increase varies among different economic sectors, with the main surge stemming from the mining industry, infrastructure and real estate investments. This shows that economic demand is not strong, and the economy is heavily reliant on investment stimulus.

Because of the limited PPI increase in consumption products sectors, the downstream consumer price index (CPI) showed moderate growth. However, the rapid rebound in raw material prices has raised costs for enterprises, so there was a relative slowdown in revenue growth, putting pressure on profitability, which in turn would affect corporate investment.

Fourth, China’s investment in property development has been curbed. In 2016, in terms of floor area, property sales jumped 22.5 percent, attracting massive investment into the sector. However, as the central government continues its tightening measures, a stand-off between home buyers and sellers seems to be cooling the property market and worrying property developers.

Fifth, in the third quarter of 2015, a gap between the growth rate of M1 and that of M2 emerged, and it has not been eliminated, though it has narrowed somehow in 2017. This means enterprises are not confident about investment, and this phenomenon will continue to exist in the short term.
In addition, small and medium-sized enterprises are struggling with financing because market interest rates are trending upward and the amount of bond financing has shrunk sharply compared to last year. The refinancing difficulties will, to an extent, raise the default rate of the bond market, thus exerting pressure on financial market stability and business operation.

Finally, the underlying cause of China’s economic slowdown is that the potential growth rate has continued to decline since 2011, and this issue was not addressed in 2016. In the past few years, through opening up, China has acquired advanced production technology and management experience, expanding production and achieving economies of scale, which has been driving the total factor productivity up. But in recent years, the growth of total factor productivity is becoming increasingly unstable, leading to the fluctuation of potential output.

As its GDP grows, China has to stop imitating and start developing its own technology. In addition to the diminishing policy dividend from the previous reform model, total factor productivity is insufficient and the growth rate is decreasing. If we cannot address this issue, China will not move from the inventory cycle to the expansion cycle.

 

Controllable downward pressure
At root, the aforementioned risks exist because the current economic rebound is a phase of economic inventory replenishment. In 2015 and 2016, the Chinese economy experienced a rapid destocking, leading to a rapid economic downturn.

The economy has now entered the replenishment cycle since PPI decline continued to narow last year and quickly turn positive in 2017. However, as the PPI month-on-month growth rate declines and reaches its floor, the inventory cycle is becoming weaker. Weak momentum in the short term and the long-term structural problems will further accumulate risks.

However, overall, the economy’s downward pressure is controllable due to the following two aspects.

First, the policy stimulus is mainly carried out through infrastructure and real estate investment, and these time-consuming projects will provide growth momentum for some time to come.

In this respect, we can see that though real estate sales may have dropped, investment is still high. Also, some companies have given up bond financing at high market rates, implying that they still have some capital and can support production for a certain period of time.

In the meantime, the international economy is in full recovery, boosting China’s exports. As a nation deeply integrated into globalization, the role of trade can never be understated.

In this light, though the growth rate has slowed, the downward pressure is largely under control and it is unlikely the economy will plummet to a hard landing. The chances of meeting the targeted economic growth rate are quite favorable this year.

 

Moderate deleveraging
The core issue China’s economy faces is the decline in productivity. At this crucial juncture of reform and opening up, the foundation for an innovation-driven Chinese economy can only be laid through financial restructuring.

Previous policies and international economic recovery are conducive to implementing financial deleveraging measures this year. However, there is a chance that the policy impact is exaggerated under the existing framework. A sharp deleveraging in a short time will breed risks and threaten financial and economic stability. To this end, it is vital to adjust policy implementation and enhance coordination.

Financial regulation is an important means of financial deleveraging. Therefore, it is essential to carry out coordinated supervision and avoid competition in practice. At present, China’s financial regulation is achieved through macroeconomic policy assessment from the People’s Bank of China on the macroeconomic level and China Banking Regulatory Commission’s micro-supervision.

In the face of rapid development of the shadow banking industry, commercial banks seek regulatory arbitrage to avoid the cost of supervision. In 2017, China’s regulatory policies made the model of regulatory arbitrage increasingly competitive. In the first quarter this year, both parties tightened regulation and this kind of competition can easily magnify regulatory requirements, making better coordination among macroeconomic policy departments urgently needed.

To inject liquidity into the market, the People’s Bank of China often resorts to a basket of tools, such as medium-term loans, alongside its regular business, enriching the term structure of interest rates it can control, and constructing a more complete operating interest rate system.

In day-to-day operations, however, the central bank is inclined to be overly concerned about the smoothness of operating interest rates, which can lead to excessive volatility in market interest rates. Consequently, there is an urgent need to establish market-oriented policy interest rates.

Excessive and rapid deleveraging will lead to bank runs, creating panics, even a financial crisis. In a way, deleveraging is like trying to walk a tight rope. For the sake of financial stability and abundant capital for infrastructure and other investment, it is better to ensure stable overall financing, draw back commercial bank funds, clarify financial risk and handle it once at a time this year.

Lastly, financial deleveraging can trigger capital outflow, setting off a currency crisis. In the event that the US Federal Reserve raises interest rates, rapid and unrestricted financial deleveraging could present a high risk of capital outflow. Hence, in 2017, we need to temporarily strengthen capital controls and maintain exchange rate stability in order to create a good environment for financial deleveraging.

 

Yu Ze is a research fellow from the National Academy of Development and Strategy at Renmin University of China.