Samantha Amerasinghe contemplates China’s options in scaling back its borrowings

China’s policy makers are aware of the dangers of credit driven asset price booms. And there’s growing evidence that the country is finally scaling back its heavy borrowings. The government has made good progress but can it sustain the pain of foregoing growth?

At China’s recently concluded National Financial Work Conference, which is held every five years to map out financial reforms, President Xi Jinping’s keynote speech reiterated the government’s focus on financial security and reducing systemic risks.

Following a period of rapid expansion in the financial sector amid the emergence of many innovative products, the government’s medium-term priority will be to contain risks – and thus ensure financial stability. Xi has stressed the importance of establishing a financial system that serves the real economy and stated that the pace of such development needs to be consistent with economic progress.

Going forward, China’s authorities will want to ensure that financial innovation benefits the real economy directly. Prudent monetary policy along with deleveraging will be prioritised while local officials will be held accountable for violating debt rules.

Since the global financial crisis, China’s debt has soared due to two factors: the government encouraged lending to support the economy and increased spending to fund infrastructure projects to bolster growth.

The credit boom that inflated asset bubbles and left companies burdened with unsustainable levels of debt led to widespread concern of a looming banking or financial crisis. And China’s credit to the non-financial sector increased to 257 percent of GDP at the end of last year (up from 142% at the end of 2008).

Interestingly, China’s total indebtedness exceeds that of the United States (253%) and other emerging economies (184%). What is most worrisome is China’s extraordinarily high level of corporate debt, two-thirds of which is attributable to state-owned enterprises (SOEs). Corporate debt continued to expand rapidly last year, pushing total debt to 264 percent of GDP at end-2016 (from 248% a year earlier).

At the same time, China’s non-financial corporate debt was the highest globally at US$ 17.8 trillion, which is about a third larger than that of the euro area.

China’s corporate debt ratio is the highest among major economies and the government has identified it as one of the most serious risks to the economy. In fact, Moody’s downgraded the country’s sovereign rating (from ‘Aa3’ to ‘A1’) for the first time since 1989 in May on the back of rising debt. This reflects expectations that China’s financial strength would erode with economy-wide debt continuing to rise as growth slows.

Recently, the People’s Republic shifted its policy focus from growth to deleveraging. With economic growth on track to reach the annual target of around 6.5 percent particularly following a stronger than expected second quarter GDP sprint of 6.9 percent year-on-year (y-o-y), the government’s deleveraging agenda looks set to continue.

The services sector that accounts for over half the economy remained the most rapidly growing segment, expanding by 7.6 percent y-o-y while consumption was the main driver of growth. Property investment appears to have been more resilient than expected with policy tightening in the sector surprisingly having a muted effect.

So what steps has the People’s Bank of China (PBOC) taken to deleverage the financial sector?

PBOC has been implementing monetary policy with a tightening bias since late last year. And it’s been increasingly difficult for cheap money to enter the system.

In particular, China’s central bank has reduced the provision of short-term lending – and this has led to an increase in short-term rates in the interbank market. It has also tried to contain credit growth through the Macro Prudential Assessment framework. This will ensure that banks maintain a pace of credit growth that’s consistent with their capital base.

Another positive sign is that the central bank has made progress in reining in shadow banking.

Banks and insurance companies are relying less on riskier wealth management products (WMPs) while the issuance of risky WMPs declined by 18 percent in April from March. Getting shadow banking under control is an important prerequisite for serious deleveraging as the sector accounts for more than four trillion dollars.

Deleveraging is likely to be a lengthy process. Progress has been made but China is not out of the woods yet. Things could potentially go wrong. The aggressive tightening of monetary and regulatory policies can lead to asset selloffs, triggering a vicious cycle of falling asset prices.

The reform measures that PBOC has taken towards deleveraging have led to an increase in corporate bond yields and higher average lending rates. Stocks, bonds, commodities and real estate have all turned strongly negative while interest rates have inched up. And rising bond yields are making it more difficult for heavily indebted companies to meet their debt obligations.

All these consequences are the price China’s government is willing to pay for reducing financial risk. But for how long will it be able to allow pressure to build on SOEs, consumers and banks before allowing credit to expand again?

While deleveraging is difficult, for now it seems clear that Xi has taken a firm stand. “Financial security is an important part of national security, and an important basis for the steady and healthy development of the economy,” he has said.