2. Page2
East Wind – Business Note No.1
“China’s Economy”
Written by Stéphane PHETSINORATH
Abstract
China remains one of the world’s most attractive
markets, and is by far the fastest-growing of all the
large emerging markets. Currently facing unique
challenges and navigating into uncharted water, the
Chinese market is exceptionally complex with long
history. This article focuses on understanding how China
has successfully transformed an afflicted and inefficient
economy into a modern and competitive economy.
How did China succeed to become the 2nd
economy of the world in less than 10 years?
The “Chinese Dream” is probably echoing to the
western “American Dream”, but they both are
fundamentally different in nature. Through this
ambitious dream, the Chinese people want to show their
determination to take revenge against years of suffering
and misfortune, aiming to achieve Chinese prosperity,
collective effort, socialism and national glory.
How is China managing the new challenges
threatening the economy?
China has kept the title of “world’s factory” for a
very long time, due to investments into building
infrastructures, boosting manufacturing capacity and
developing export industries. Investment-based fuelled
double-digit growth, but also considerably degraded the
prospect of private consumption growth inside the
country. Creating an unbalanced economy, China will
have to find a solution for some difficult issues, among
them: the GDP growth slowdown, the rising debt
situation and the “Shadow Banking” risks.
The Chinese market is mainly driven by big
state-owned companies under influence of the
government, as the officials take necessary precautions
to control very closely every sensitive industries
(including healthcare sector). The economy is less
subjected to the “Market Rationality” (also called
“Efficient Market” rule), meaning that the investment
decisions are not exclusively based on the real
performance potential. In other words, investors tend to
invest their money into very risky state-backed
operations, thinking that China will always guarantee
their money while betting on very risky high returns. As
for today, the investment-based growth starts to show
dangerous signs of weakness, while the government is
trying to rebalance and deleverage the whole economy.
The paradox is that, more and more money is
available on the market, but it is even harder and
expensive to secure investments especially without solid
guarantees. The lack of money has necessarily led to the
rise of the “Shadow Banking” system, where companies
can find plenty of non-regulated and off-book shadow
funds. With the prominent surge in “Shadow Debts”, any
defaults would inevitably hurt the Chinese banking
system and the economy.
How will China plan the landing of its
economy?
The Chinese government has officially declared that
it will crackdown the “Shadow Banking”, forcing rogues
entities to get all their shadow operations back in their
books and under regulated supervision. But the timing is
not fortunate, as China is accusing a predictable
slowdown in the economy, forcing the government to
put in place several “mini-stimulus” investment
packages, targeting key industries. Along with a
population aging so quickly, the government will need to
face challenging healthcare issues, such as a rise in
cancers, in chronic and infectious diseases, along with
rising healthcare expenditures. Thus, China’s healthcare
market is expected to be valuated at $500 Bn in 20141
and $1,000 Bn in 20202
, on the verge of being the 2nd
largest Healthcare market (after the US market).
1
“Healthcare & Life sciences in China – Towards Growing Collaboration”,
KPMG, Mar. 2013 (source: China MOH).
2
“Healthcare in China – Entering Uncharted Waters”, McKinsey, Sep. 2012.
3. East Wind – Business Note No.1 – China’s Economy September 2014
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Part I – The rising economy
“中国梦” – the “Chinese Dream”
The words “Chinese Dream” may somehow owe its
early use to Thomas L. Friedman, a columnist for
the New York Times. In October 2012, he raised this
topic in “China needs its own dream” article, wondering
if “Xi have a ‘Chinese Dream’ that is different from the
‘American Dream’?”3
For the first time, Xi used the same words “Chinese
Dream”, in November 2012 4
, describing the “great
rejuvenation of the Chinese nation”, as achieving the
“Two 100s”: starting from a “moderately well-off society”
by about 2020 (100th
Anniversary of the Chinese
Communist Party) and becoming a “fully developed
nation” through modernization by 2049 (100th
anniversary of the People’s Republic).
“A new ‘Chinese Dream’ that marries
people’s expectations of prosperity with a
more sustainable China”.3
The “Modernization”5
means China regaining its
position as a world leader in science and technology, as
well in economics and business; the resurgence of
Chinese civilization, culture and military might, and
China participating actively in all areas of human
endeavor.
The beginning of the rise
The Chinese new economic era begins with Deng
Xiaoping in 1980s, initiating the “liberalization” of the
market6
by opening of the Chinese economy to foreign
investment in the 1990s.
Paving the road to the future economic road,
“reforms in China transformed it from a highly protected
market to perhaps the most open emerging market
economy by the time it came into the WTO at the end of
2001”7
. On the 17th
September 2001, the World trade
Organization (WTO) has successfully accepted the
application of China’s membership. Over more than 15
years of negotiations, the 900-pages legal text will lead
3
“China Needs its Own Dream”, New York Times, Oct. 2012.
4
“复兴之路 – The Road to Revival” exhibition, Beijing, Nov. 2012.
5
“Xi Jinping’s Chinese Dream”, The New York Times, June. 2013.
6
“The China Dream – The Quest for the Last Great Untapped Market on
Earth”, Joe Studwell, 2002.
7
“Trade liberalization and its Role in Chinese Economic Growth”, IMF and
National Council of Applied Economic Research Conference, Nov. 2003.
the way to the formal acceptance of the 142 WTO
Members. “International economic cooperation has
brought about this defining moment in the history of the
multilateral trading system”, said Mike Moore, WTO
Director-General, at the conclusions of the meeting of
the Working Party on China’s Accession.
“History demands we welcome China into
the world trading order”.8
The entry into the organization does not come
without a price, among some of the key commitments
undertaken9
, China had to relax over 7, 000 tariffs,
quotas and other trade barriers:
China will provide non-discriminatory treatment to
all WTO Members. All foreign individuals and
enterprises, including those not invested or
registered in China, will be accorded treatment no
less favorable than that accorded to enterprises in
China with respect to the right trade.
China will eliminate dual pricing practices as well as
differences in treatment accorded to goods
produced for sale in china in comparison to those
produced for export
Price controls will not be used for purposes of
affording protection to domestic industries or
services providers
Within three years of accession all enterprises will
have the right to import and export all goods and
trade them throughout the customs territory with
limited exceptions.
The Foreign Direct Investments (FDI)
Inbound FDI has definitely played a crucial role in
China’s economic development, because FDI induces
activities with higher productivity and more advanced
technologies. All the FDI opportunities have been mainly
restricted to manufacturing and export industries, which
will become a pillar of growth.
The following decade (2000-2010) can be
considered as one of the best decades in global
economic history. And by all accounts, FDI in China has
been one of the major success stories, receiving about
8
“The national foreign trade council’s world trade dinner”, WTO
Director-General Mike Moore speech, May 2000.
9
“WTO successfully concludes negotiations on China’s entry”, press release,
Sep. 2001.
4. East Wind – Business Note No.1 – China’s Economy September 2014
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20% of all FDI to developing countries over 2000-2010.
China has become the world’s largest recipient of FDI
during the 1st
semester 2012 with over $60 Bn 10
,
totaling over $117 Bn11
in 2012. Those FDI investments
have produced around 2.5% of GDP growth in average
over the last five years10
. Cautious and patient in
tackling the process of “liberalization”, very specific
coastal cities or regions have been opened up to foreign
investment, creating export-oriented special economic
zones (e.g. Shanghai Free-trade Zone12
).
The demographic “sweet spot”
China has been famous for the implementation of
the “one-child policy” to curb the scary and uncontrolled
boom of the population. Fortunately, this drastic
measure will put China in an exceptional “sweet spot”,
allowing the country to achieve an incredible
double-digit growth during a long period.
The establishment of the People’s Republic of China
in 1949 was accompanied with an unprecedented baby
boom, and during the years of 1950s and 1960s, a huge
number of Chinese people were born. By 1970s, there
were so many young people in China, fearing that the
rapidly growing population might place an untenable
burden on the Chinese economy, and then jeopardizing
any sustainable and continuous development. In 1980,
the government imposed the one-child policy to curb the
uncontrolled demographic boom.
As a result of rapid decline in birth rates and death
rates over more than 40 years, the working-age
population (from 15 to 64 years) jumped from 56% to
more than 73% in 201113
(other developed countries
10
“Foreign Direct Investment – the China Story”, the world bank, July 2010.
11
Source: Ministry of Commerce of the People’s Republic of China.
12
“Financial Reforms for the Shanghai (Pilot) Free Trade Zone: Slowly
Coming into Focus”, Hogan Lovells, April 2014.
13
Source: Trading Economics – Population ages15-64 (% of total) in China.
usually averaging at 62%). This demographic distortion
placed China in a demographic “sweet spot”, where a
huge number of postwar children have been able to
produce very fast economic growth and with only very
few workers aging into retirement.
Part II – The new challenges
The real “Truth” behind China’s growth
Outside China, people tend to legitimately assume
that the country's impressive economic growth is mainly
due to exports. Indeed, China’s entry in to the WTO has
triggered an export boom, with exports averaging
nearly 30% of the annual growth from 2002 to 2007.
However, this notion has always been too much
exaggerated and is now a plain false assumption. The
incredible double-digit growth has been mainly fuelled
by continuous investments targeting infrastructures
(roads, railways, real estate, and energy),
manufacturing and export industries. Meanwhile, the
private consumption continued to lose share in the GDP
growth of the country, caused by low wages and low
purchase power in the middle class.
“The No. 1 task for any Chinese leader:
securing fast enough economic growth to
shore up employment and social stability”.14
Under Mr. Hu leadership (2002-2012), China’s
growth has averaged more than 10% per year during
the ten past years. China has also won plaudits for an
effective response to the financial crisis, keeping growth
and employment on track and contributing to the world
recovery. Rapid growth catapulted China up the global
economic rankings, overtaking the UK, France,
Germany and Japan to claim second place, behind only
the United State, and made the Chinese market a target
for the world’s corporations. In fact, China grows thanks
to high levels of investment, far higher than those we
could see in the previous “Asian Miracles”, such as South
Korea and Japan. Consolidating large-scale production
capacity and high quality labor forces, China has been
able to take over the American manufacture leadership
with 19.8% vs.19.4% of the global manufacturing
output in 201015
. The currency depreciation (also known
14
“Charting China’s Economy: 10 Years under HU”, The Wall Street Journal,
Nov. 2012.
15
“China Became the World’s Biggest Manufacturer in 2010. US Loses
5. East Wind – Business Note No.1 – China’s Economy September 2014
Page5
as “currency war”) has played a major role to boost the
policy of export-led growth, leading to a lower exchange
rate and making China extremely competitive against
other countries.
The corollary of this is the low levels of private
consumption from the households, despite the
remarkably high growth. The share of household income
in the national income was continuously decreasing
during the same period, creating a very weary situation
for the private consumption. The export-oriented
strategy led to low wages, low investment incomes and
limited purchase power. Creating a feeling of insecurity
that explains why precautionary saving rate is sharply
increasing, with the rise in uncertainties and reforms in
pensions, healthcare and education.
Over the last two decades, there always have been
difficult and expensive to access adequate healthcare in
China. While reaching about 5% of the GDP
16
, the public
expenditure share continued to fall, inducing
poor-quality healthcare provision that drives rural
inhabitants to seek better services in urban regions. But,
the high cost of healthcare in large cities has resulted in
a rising number of people being priced out of treatment.
Concerns about the affordability of healthcare and the
potential for future illness, combined with the lack of any
effective social protection scheme, mean Chinese
households plan well ahead for future healthcare
expenses.
Crown Held since 1895”, Finfacts, Mar. 2011.
16
“OECD Health Data 2013”, OECD, 2013 (source: China Health Statistics
Yearbook).
The growing risks of “bad debt”
A decade of successful investment-led growth was
based on the addition of tens of millions to its working
population and flourishing capital stock, along with strict
control on the wage and the voluntarily depreciated
currency. But some economists predict that this kind of
unbalanced economy development is not sustainable,
those dangerous imbalances, without reforms from the
government17
, would one day send China's economy off
a cliff.
As China responded to the financial crisis, splurge
of loans have been unleashed on the market, making
China one of the most successful country to resist to the
sharp contraction of the financial crisis, but inevitably
hurting deeply any long-term growth prospects. The
ratio of outstanding credit to GDP has risen from 153%
in 2007 to 209% in 201218
, including corporate bonds,
trust loans, micro lending and pawn shops, and all other
informal lending. This 56% increase is second only to
Japan’s 63% rise, and higher than the 22% in the US. In
2013, the total credit outstanding is expecting to break
through over 240% of GDP, and continue rising from
there at even faster pace 19
. Charlene CHU, senior
director of Fitch Ratings, was among the first to flag the
growth of China’s massive shadow banking sector.
“Such a rapid expansion of credit will
almost inevitably be followed by an increase
in credit defaults”.20
According to the National Audit Office in 2011,
China's state auditor, local governments have already
17
“China’s Economy ‘Not Going over a Cliff”, JPMorgan, May 2014.
18
“The China Credit Conundrum: Risks, Paths, and Implications”, Goldman
Sachs Global Economics, Commodities and Strategy Research, Jul. 2013.
19
“The true Chinese Bubble: 240% of GDP and Soaring”, Zero Hedge, Jan
2013.
20
“Fitch China Analyst CHU, Who Warned on Debt, Leaving Agency”,
Bloomberg News, Jan 2014.
6. East Wind – Business Note No.1 – China’s Economy September 2014
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accumulated an outstanding debt of $3 trillion (+67%)21
,
including contingent liabilities and debt guarantees. In
2013, the total debt of the government is reaching 30.3
Tn rmb equivalents to 53% of the GDP, but doesn’t
exceed the “red line” of 60% of GDP. For comparison,
the US has a ratio of 93%, while Japan’s ratio is over
22%22
.
“We expect the [central] government to
restrict the borrowing behaviors of local
governments”.23
In many countries, governments struggle to
contain their debt, but in China, the authorities struggle
even to count it. In 2011, National Audit Office of the
People’s Republic of China published a first nationwide
audit “2011 年第 35 号：全国地方政府性债务审计结果 –
Nationwide Local Government Debt Audit Report”. The
extent of local government borrowing revealed by the
report is concerning, as per the increase in the size, the
variety and the complexity: roads, bridge, utilities,
homes, lucrative business hubs and unoccupied ghost
towns.
However, some economists don’t believe that a
Chinese financial crisis could be plausible in the
immediate future.
1. China is sitting on more than $5.94 Tn foreign
assets (by the end of 2013); this is more than half of
the country’s $8.3 Tn GDP; even more than the
money in foreign reserves than Brazil, Russia, India
and South Africa combined altogether24
.
2. The international reserve account includes $3.88
Tn25
, which accounts for 65% of the total foreign
assets held by China; China is the world’s largest
foreign holder of U.S debt, with around $2 bn in
outstanding treasury securities.
3. Almost all government debt is denominated in rmb
and owned by domestic entities, meaning the
People’s Bank of China can prevent a public debt
crisis with its unlimited capability for liquidity
supply.
4. Both the central and local governments own quite
large good assets ; The CASS (Chinese Academy of
21
“Chinese Local Government Debt Balloons to $3 Trillion”, Telegraph, Dec.
2013.
22
“Extent of Local Debt in China Laid Bare”, Financial Times, June 2011.
23
“China $3 Trillion Local Government Debt Stirs Alarm”, Reuters, Dec. 2013.
24
“China’s Foreign Assets More than Half its GDP”, Forbes, Apr. 2014.
25
“China’s External Financial Assets near $6 Trillion”, China Daily, May. 2014.
Social Sciences) report shows that China’s net
assets exceeded $49.3 Tn in 2011, which is almost
three times China’s total indebtedness.
5. Despite the slowdown, China still has high economic
growth momentum and stable fiscal revenue
growth.
In fact, no other country is comparable to China, as
there is more money held by China’s international
reserve than all the BRICS (Brazil, Russia, India, China
and South Africa) combined together. Of course, this
doesn’t mean that the government should not tackle this
growing issue, but at least a Chinese financial crisis is
not an immediate threat to the worldwide economy.
Chinese government(s)
We usually refer to a government as a single and
whole entity, acting as single-voice to direct the country.
However, this assumption is not reflecting the reality of
the Chinese governments(s). The governments are
multiple and endorsed with different responsibilities, but
all acting as representatives of the central government.
The concept of central-local governments is crucial to
understand how the public forces will shape the future
Chinese economic landscape.
In China, the balance of power between
central-local governments has been an explosive
subject, with numerous waves of centralization and
decentralization through the XXth
century. It is however
crucial to understand, that here lay the key
understanding of the Chinese government’s mechanics.
In 1950s, the Maoist totalitarian model 26
has taken
place, with all local governments just merely handing
down the decisions from the central government.
County and township/town governments are clearly
important governmental bodies, as because they
actually govern China on behalf of the central
government. Although, there were some major
decentralization initiatives happened between the
1950s and 1970s, as the Chinese economy suffered
numbers of inefficiencies such as waste of resources,
rigidity, and lack of local initiatives.
In 1990s, the relation between central-local has
taken a sharp turn, after a decade of decentralization,
26
“Local Government and Politics in China: Challenges from Below”, Yang
Zhong, May 2003.
7. East Wind – Business Note No.1 – China’s Economy September 2014
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the center is progressively losing the fiscal control of the
nation. And in 1994, the central government ordered the
centralization of the most lucrative sources of revenue,
nevertheless, the local spending responsibilities has
always remained roughly unchanged, leading to a
consequent mismatch between budget and
expenditures at local levels 27
. Studies show that
central-local relations tend to be centered on around the
“money-talk” principle, the fiscal control, and the
revenue-sharing problematic.
As matter of fact, every provincial government has
run budget deficit every year since the tax reform in
1994, although the local governments budget was
basically balanced from 1985 to 199328
.
In this game of power, the central government need
to approve the budget of provincial governments and
covers every local government’s fiscal deficits through
transfers. In a consolidation point of view, the local
governments would have no deficits after the transfers
from the central government. And besides the standard
budget, local governments may add extra-revenue in
their books, collected from governmental agencies,
27
“Local Government Financing Platforms in China: a Fortune or
Misfortune?”, International Monetary Fund, 2013.
28
“China’s Central-Local Fiscal Disparity”, Lin Shuanglin, 2007.
governmental institutions or state enterprises.
Local governments often initiate their own projects
and finance them with their own funds, which may be
out of the oversight and the supervision of the central
government. Those projects are financed either by
extra-revenue or off-budgetary revenues. Many local
governments are actually in severe fiscal difficulties,
leading them to look for off-budgetary revenues (this
extra budget is sometimes called “ 小 金库” – “Little
Golden Box”), but most of them may be not legal.
Under China’s laws, local governments are already
barred from borrowing directly from banks or investors
to protect country’s fiscal health. Despite not being able
to borrow directly, local authorities found creative
solutions, with tacit approval of Beijing, to raise funds
predominantly from banks through Local Government
Financing Vehicles (LGFVs). As local governments
control some major investment projects, and key
resources like lands, it offers multiple opportunities to
leverage funds to finance projects or even just patch up
a part of the budget deficit, opening the doors for graft
and corruption at nationwide scale, reminding that the
funds are issued from bonds or equity-like instruments
to insurance companies, institutional investors and
individuals. Ironically, China’s structured and regulated
financial system has given rise to the new “Shadow
Banking” system.
During August and September 2014, the Chinese
National Audit Office dispatched 54,500 auditors across
the country scrutinizing local government accounts.29
The results shows that the “Augmented Fiscal Deficit”
29
“Shadow Banking Risks Exposed Local Debt Audit: China Credit”,
Bloomberg, Jan. 2014.
8. East Wind – Business Note No.1 – China’s Economy September 2014
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yields a total of 17.9 Tn rmb, including 10.9 Tn rmb of
outstanding loans and 7 Tn rmb of explicitly and
implicitly guaranteed debt30
. Representing 56% of the
GDP, the debt level surged by +70% to compare with
the 10.7 Tn rmb in 201031
, then it is reasonable for the
policy makers to fear a wave of defaults destabilizing the
public finance and the financial market, as all the debt
are backed up by local governments.
“Shadow Banking”
“Shadow Banking” is, of all the other economic
dangers to flare up, the most dangerous deviance from
the regulated financial system. Accessing loans from the
banks is today a very difficult challenge, inhibiting
consequently firms to build decent working capital to
sustain their normal operations. In the past, it would be
difficult to imagine Chinese companies facing financial
constraints, given the substantial liquidity in the market
system and the government-controlled very low interest
rates. However, decades of government influence have
disrupted the market, where large and cash-rich
state-owned companies crumble under easy-accessible
money, whereas smaller firms struggle to even pay their
bills. In fact, the overall demand for cash continues to
rise rapidly, but not everyone can be equitably eligible,
due to years of lending practices and regulatory
framework that favor state owned companies over
private firms.
On downward spiral investment and debt reduction,
Premier Li confirms that China will pursue “prudent”
monetary policy. As a matter of fact, M2 money supply
growth hit lowest level in more than a decade, +13.6%
in 2013, but still ahead of the People’s Bank of China’s
(PBC) target of 13%32
. To balance the world’s second
economy, the new financial reforms are trying to reduce
the dominance of banks and deleverage its economy. At
the same time, Premier Li confirmed that the central
bank would “neither loosen nor tighten money supply”
in the coming year, adding that the government would
guarantee “adequate” liquidity for 2014. But according
to the business environment survey conducted by the
World Bank, numbers of Chinese firms complain about
access to financing as a key obstacle to their business is
significantly higher than in other Asian economies.
30
“Local-Government Debt: Counting Ghosts”, The Economist, Jan. 2014.
31
“Fears After Key China Debt Level Soars 70%”, Financial Times, Dec. 2013.
32
Source: National Development Reform Council (NDRC).
The M2 Money supply:
In economics, the M2 money supply is a key
economic indicator to evaluate the monetary assets
available in an economy for a specific time (money
availability, price level, credit level and inflation). The
“money” can be classified into different forms and
categories, from M0 to M3 linked to their “liquidity level”.
Limiting the M2 money supply would restrict the access
to cash money available on the market, but an increase
in M0-M2 money supply could for example stimulate the
inflation. However, the management of the M2 money
supply is a very complex task for any governments and
influences directly the market and the costs of the cash
or investments.
For example, if the bank has currently 100 RMB
physical currency note in the vault (M0), and emits
credit based on the country regulation of 10% Reserve
Requirement Ratio (RRR), the bank could lend 10 times
the amount (1,000 RMB), classified as M2 money.
Using this economic mechanism, it is possible to
multiply the potential of growth (but also the risks) by
“leveraging” the whole economy.
Zhou Xiaochuan, governor of the PBC, said in a
statement included in the 2013 annual report: “the
central bank will push forward the financial reform
vigorously, maintain a stable financial market, increase
the standards of financial services and management,
and support the restructuring of the economy”. In 2013,
the banks had 71.9 Tn rmb worth in outstanding loans,
posting a 14.1% growth, according to the central bank,
the outstanding amount of short-term loans and bill
financing to enterprises and other sectors increased by
12.1% up to 26.1 Tn rmb, and medium to long term
debt rose by 9% to around 28.2 Tn rmb33
.
The Chinese central bank shows already that
“Shadow Banking” money now accounts for nearly 1/3
of the total outstanding credit, with 47 trillion rmb
representing 84% of the GDP34
. Meanwhile, credit at
viable cost is being so fiercely rationed, but many
loosely regulated institutions have plugged the lending
gap and there are simply reckless in their operations,
leading to such dramatic fate as “Shanghai Chaori Solar
33
“China’s Central Bank Vows to Fight Credit Crisis”, Forbes, Oct. 2014.
34
“Economic Danger Lurks in China’s Shadow Banks”, Financial Times, Jan.
2014.
9. East Wind – Business Note No.1 – China’s Economy September 2014
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Energy Science and Technology” being the 1st
corporate
bond defaulting on public domestic bond, in March 2014.
The China Banking Regulatory Commission (CBRC)
is targeting the full implementation of the Basel III35
rules in 2018 36
, aiming 11.5% in total capital
requirement for Systemically Important Financial
Institutions37
. The CBRC has commissioned a national
and regional bank stress following the spike in bad loans,
and the tests covered 17 domestic banks that are
considered systemically important and account for 61 %
of assets38
. Worst case scenario for events such as a 400%
rise in non-performing loans (NPLs), increases in bond
yields, large changes in rmb exchange and economic
growth slowdown to 4%. Even under heavy stress
scenario, such as 15% point rise in NPLs, the capital
adequacy ratio of the whole banking system would not
fall below 10.5%39
. Although, municipal level banks
have not yet been tested, undermining the confidence of
small depositors in the municipal banking institutions,
as shows the recent multi-day “bank run” in Hangsu
Sheyang Rural Commercial Bank. As a matter of fact, no
official deposit insurance program is in place, leading
small depositors overreacting to the rumor of the
collapsing bank.
As the amount of outstanding loans is skyrocketing,
the whole banking system is today exposed to the risks
of bad debts, especially when the dividing wall between
shadow banks and their better-regulated counterparts is
35
“International Regulatory Framework for Banks (Basel III)”, Bank for
International Settlements, Jun. 2011.
36
“Basel III and its Implementation in China’s Banking Industry”, Y. ZOU,
University of International business and Economics Beijing.
37
“商业银行资本管理办法（试行）- Rules Governing Capital Management of
Commercial Banks (Provisional)”, China Banking Regulatory Commission, Jun.
2012.
38
“China Banking System Passes Stress Tests - POBC”, Reuters, Apr. 2014.
39
“中国金融稳定报告 2014 – China Financial Stability Report”, The People’s Bank
of China, Apr. 2014.
very thin. China’s shadow lenders are mix of traditional
banks with off-balance-sheet operations, trust
companies, insurance firms, pawnbrokers and other
unlicensed informal lenders. Due of a lack of
comprehensive regulatory framework, there is no way
to really assess those “subprime-like” investments and
their real performance.
“In 2011, China Credit trust (Credit Equals Gold #1)
loaned 3 Bn rmb to Wang Pingyan – a coal mine operator
in the northern province of Shanxi – which made an
ill-fated decision to scale up investment dramatically
just as coal prices peaked. The company completely
collapsed soon after receiving the loan. If the pain had
been confined to China Credit it would have been bad
enough, but making matters worse, the investment
product was marketed by Industrial and Commercial
Bank of China, the country’s largest lender”40
. In the
end, an anonymous entity bailed out all the investors by
covering entirely their principal, though not the full
interests. It would not be surprising if the unknown
“white knight” had his office on Chengfang Street in
Beijing, by coincidence home to the People’s Bank of
China.
Chinese investors who lend money to heavily
indebted miners or property developers are not crazy.
They are making a calculated gamble that the
government or state-owned banks will bail them out if
they get into trouble. One that may has still been proved
mostly correct until now.
Part III – The economic reforms
Rising debt peril
The increasing fears of a hard landing for the
economy push the government to enforce fiscal and
financial discipline on the local governments and the
financial market.
“Fears of a property crash, corporate
defaults and austerity in the age of
anti-corruption all came to naught”.41
However, with a credit-to-GDP ratio at 200% and
average financing costs of roughly 7%, Chinese
40
“Shadow Banking Bolsters China as Credit Tightens”, Reuters, Jul. 2013.
41
“China’s Debt-to-GDP 200% and Counting”, The Economist, Jul. 2014.
10. East Wind – Business Note No.1 – China’s Economy September 2014
Page10
borrowers will now need to generate cash-flow growth of
14% to cover their interest payments without eroding
their profitability or being forced to borrow yet more41
.
This is indeed a high requirement in an economy which
is running only at 7.5% GDP growth. In the last
semester 2013, the PBC sent a strong warning message
to the credit market, allowing the short-tern interbank
rates to surge from their normal level of 3% to as high
as 9%. The shockwaves did not stop there, as the banks
immediately scrambled for deposits to secure more
funds.
Unfortunately, the situation doesn’t seem to get
better in 2014, as China has given an explicit “go-ahead”
to local governments to issue public bonds as a solution
to roll over their debt and avoiding default. Also called
the China’s “Minsky moment”, overstretched investors
must finally repay their debts. Local government are
facing with an incredible mountain of maturing loans
which they have no money to repay, and could probably
qualify as a “Ponzi” scheme. Unable to repay neither the
principals nor the interests, the debt roll-over is not a
long-term solution, as the debt burden along with the
debt cost will both increase.
In fact, the only thing that hold the whole Chinese
banking system intact is based on the unspoken
guarantee of the central government over the local
government, the state-owned companies and the major
banks: “this precarious equilibrium could last a bit
longer but not much longer”, says Société Generale’s
economist Wei Yao, “rising defaults and non-performing
loans are inevitable, and this will further stifle the
growth rate”
Reforming local governments
Chinese officials have long worried about the
amount of debt racked up by local governments, short in
budget and not allowed to get funds from banks. LGFVs
secured a large amount of money to achieve impressive
growth even in the immediate aftermath of the global
crisis.
According to IMF, the consolidated local
government off-budget augmented public debt is
evaluated at a starting point of 12.7 Tn rmb in 2010,
representing around 45% of the GDP42
. “Nonetheless,
42
“Fiscal Vulnerabilities and Risks from Local Government Finance in
the augmented debt [45% of GDP] is still at a
manageable level”.42
Assuming a normalization of the augmented fiscal
deficit over the medium term and worst case scenario,
consistent with past experience in other emerging
countries, IMF have simulated multiple possible
projections. And despite the worse stress possible, a
combination of interest rates increase by 4%, GDP
growth slowdown by 4% and an outstanding 10% of
GDP increase in the debt ratio, the cumulated off-budget
augmented debt will be on a downward trajectory within
2018
40
.
Others challenges should also been mentioned,
including the reliance of local governments on land sales,
which distorts the real estate market and the rollover
risk from the maturity structure of existing borrowing43
.
The accumulation of these two factors may heavily
affect the recovery of the local government debt. Most
infrastructure projects are not expected to generate
significant cash flow for 10 years or even longer. The
majority of the maturing debt was either rolled over or
repaid by new borrowing: growth in debt issuance is
much higher than the growth in total debt stock,
China”, International Monetary Fund, 2014.
43
“Swelling Debt Spreads among China’s Local Governments”, The Wall
Street Journal, Feb. 2014.
11. East Wind – Business Note No.1 – China’s Economy September 2014
Page11
meaning that old debt are migrating to more expensive
sources of financing and raising the effective cost, and
impacting on the debt recovery.
The “Shadow Banking” crackdown
The government has already done the first step to
tackle the looming “shadow debt bomb”, with the
release of the new set of guidelines “国办发【2013】107
号文” – “State Council [2013] Document No. 107”.
The regulatory bodies are setting a centralized
supervision aiming to improve the regulation of the
massive “Shadow Banking” activities44
:
1. Unlicensed unregulated credit intermediation
(online finance companies)
2. Unlicensed but lightly regulated credit
intermediation (credit guarantee companies and
micro-credit companies)
3. Licensed but insufficiently regulated financing
activities (money market funds, informal asset
securitization and some wealth management
businesses)
The recent figures show that the crackdown is
happening, as China’s total credit growth is decelerating,
despite huge surge in bank lending. In 2014, the M2
money growth decreased from 13.4% in May to 13.2%
in April, while the new bank loans growth increased by
12.4% during the same period.45
Banks had to move
more and more of their off-balance-sheet operations
back in their book, which are tightly regulated. However,
the overall credit growth remains high with double-digit,
up to 14.7% at the end of June compared with last year.
However, big state-owned banks largely dominate
the market and have generally being net-suppliers of
liquidity while the smaller banks net-purchasers in the
interbank market. For example, the cap on bank deposit
rates is also hindering the smaller banks from more
aggressively competing with the larger state-owned
banks, locking down the access to cheaper but regulated
loans. Removing the cap on deposit rates will allow the
smaller banks to better compete with the larger ones,
and could increase deposit rates from its present
artificial low rates.
44
“China is Getting Serious About its Crackdown on Shadow Banking”,
Business Insider, Jan. 2014.
45
“Economists React: China’s Bank Loans Surge, Total Credit Growth
Doesn’t”, The Wall Street Journal, Jun. 2014.
Rebalancing the economy
There is no doubt that any attempt to correct the
imbalance between investment and consumption will
result in slower growth. “The only question is: how much
slower?” 46
According to the past experience, other
countries such as South Korea or Singapore had their
investment peaked up to 40% in 1996. Then, the
investment growth rate normalized over the following
decade. China is today already taking measure to plan
the “balancing act” of shifting the economy
progressively toward private consumption based.
China’s current Investment-to-GDP is extremely
high with 47% of the GDP (ranking 5th in the world)47
.
The latest estimation being 54%, the biggest surge in
the ratio since 1993, the current model growth may
have run its course, and the IMF has evaluated at 20%
the possibility of an upcoming crisis in China in the
current situation48
. Summarized by Premier Li Keqiang,
in 2012: “The problem of imbalanced, uncoordinated,
and unsustainable development is still serious”49
The economic-policy adjustment has one principal
objective, shifting China from a production-oriented
economy to one centered around household
consumption. The share of household consumption in
GDP fell from 44% in 2002 to 34.9% in 2010, way below
the level in the U.S., or China’ Asian neighbors. In 2011,
it ticked up to 35.4%. That’s still very low in
46
“Emerging Markets: as the Tide Goes Out”, Goldman Sachs, Dec. 2013.
47
Source: CEIC.
48
“Is China Over-Investing and Does it Matter?”, International Monetary Fund,
2012.
49
“Thoroughly Applying the Strategy of Boosting Domestic Demand”, 求是
Journal, Apr. 2012.
12. East Wind – Business Note No.1 – China’s Economy September 2014
Page12
international and historical comparison, but it’s a move
in the right direction. In 2012, the growth in household
income has accelerated past the GDP, announcing the
beginning of the right trend.
If China is to rebalance growth towards greater
dependence on household consumption, improving the
distribution of national income between profit and
household income appears to be a quantitatively
important factor. On this front, the country’s leadership
has already taken some tentative but encouraging steps.
Among the very important measures, the government is
planning to release a plan to raise the dividend payouts
of state-owned companies50
and to use the profits to
strengthen social-security funds 51
. In 2007,
state-owned companies have been requested to share
the profits up to 10%, but the objective is to reach 30%
by 2020 52
. The plan still requires approval, but its
disclosure suggests that there is a realistic possibility it
will be implemented and help to curb the investment
appetite of state-owned companies while shifting wealth
to Chinese households.
Another important objective is to succeed in fixing
the healthcare system, because it would largely limit the
related household expenses on healthcare, thus
reducing financial strain on the citizens. Precautionary
savings would decrease along with the healthcare
reform, leading to more dynamic increase in
consumption and investments in the economy.
Beginning with the 12th
5-year plan (2011), the
government has committed to fix the wobbly healthcare
system, and for this reason, it is logical to expect an
important surge in the national healthcare expenditure
proportion in the future years.
50
“China’s State-Owned Sector Gets a New Boost”, The Wall Street Journal,
Feb. 2014.
51
“SOE Dividends: How Much and to Whom?”, World Bank, Oct. 2005.
52
“Dividends to Increase at Central State Firms”, China Daily, Mar. 2007.
An explicit official deposit insurance scheme has
never been implemented, but long discussed during two
decades (since 1993). The financial reforms aim to build
a financial safety to protect public interests and enable
to accuse the potential failure of any financial
institutions 53
, without crashing the market 54
. All
commercial banks will be required to deposit a portion of
their funds into a deposit insurance institution, and then
the safety measure would protect the depositors in the
event of a bank collapse. This reform will lead one step
ahead the liberalization of the market under transparent
regulatory supervision, and away from the concept
where “everything is backed from the government”. As
mainland banks face greater risk as interest rate
liberalization intensifies competition and bad loan risks
rise amid a slowdown in growth.
Further reforms in the equity market are also
important, considering Chinese investments are fully
financed through domestic savings, household
consumption will likely increase with banking-system
reform and by relinquishing control on interest rates55
.
In the past years, as the domestic equity market has
been embroiled in brokerage scandals, investor
confidence in the market has been low. However, large
Chinese enterprises and brand names have yet to enter
the market in any major way. Typically, the presence of
large corporations and well-known brands can
encourage households to participate in the equity
market. In this context, expansion of mutual and
pension funds are also steps to help increase indirect
holding of equity among households.
The FDI has also an important role to play, by
attracting the right nature of FDI to support sustainable
growth in the future. China would be able to boost the
consumption, by exploring the possibility of opening
more key sectors such as finance, service or
healthcare 56
. Nevertheless, the FDI strategy will be
much more selective and focusing on high value and
high potential industries, aiming to increase
consumption, to solve the pollution issue, and the future
needs in energy or more advanced technologies57
.
53
“Does Deposit Insurance Increase Banking System Stability?”, IMF, Jan.
2000.
54
“Deposit Insurance and Crisis Management”, IMF, Mar. 2000”.
55
“China’s Monetary Policy and Interest Rate Liberalization”, IMF, May 2014.
56
“A New Momentum for FDI Reforms in China”, Rhodium Group, Aug. 2013.
57
“A More Open Economy? The Decision’s Impact on China’s ODI and FDI
Activities”, KPMG, 2013.
13. East Wind – Business Note No.1 – China’s Economy September 2014
Page13
“Deleveraging or growing”…？
As the economic growth continues to lose
momentum, the challenge is to negotiate an appropriate
“landing” of the economy. The slowdown may be felt
very hard in some key sectors (export, real estate,
railway, etc.), and the question being whether China can
stomach to weather a period of relatively sluggish
expansion. Any attempt to stabilize the economy would
require getting the credit situation under control, fixing
the banking system and starting to deleverage the
whole economy away from the dominance of banks.
“They are trying to engineer a gradual
deleveraging process…”58
However during the second quarter 2014, China
was forced to use successful stimulus measures to
redress the growth to the targeted 7.5% growth,
releasing some downward pressure on the economy.59
China was hitting an 18-month slowest expansion with
7.4% during the first quarter60
. Using targeted stimulus,
the central bank lowered the bank reserve requirement
ratio (RRR) to finance the agricultural sector or smaller
companies, along with a panel of tax breaks
opportunities for companies. Leading to rising debt level,
the increase of M2 money supply exceed economists’
expectations, as China is rushing to fund rail, social
housing and energy projects designed to produce
growth.
“…without blowing the whole thing up”.61
As economic growth is slipping away, the
government will continue to roll-out targeted measures
in the second half of 2014. For example, local
governments face growing pressure to spend their
budgets quickly and completely. Any non-allocated
budget money by the end of June would be called back
by the central government in September 2014. As
matter of result, the fiscal spending in June jumped 26%
from a year earlier to 1.65 Tn RMB62
.
58
“Deleveraging Has Finally Begun in China”, Business Insider, Nov. 2013.
59
“China GDP Grows 7.5% in Second Quarter”, The Wall Street Journal, Jul.
2014.
60
“China Fears it Could Miss Target as GDP Increases at Slowest Rate for 18
Months”, The Guardian, Apr. 2014.
61
“Trying to Deleverage China Without Blowing Up the System”, The
Telegraph, Jan. 2014.
62
“China’s Credit Growth Offers Encouraging Signs for Economy”, The Wall
Street Journal, Jul. 2014.
Conclusions
Rebalancing of the economy has been proceeding in
line with the 12th 5-Year Plan. The importance of up
going trend for the private consumption in the economy,
continue to increase, with the size of the tertiary
industry largely equalizing the secondary industry (since
2012). There are also signs that labor share of income
has picked up, with both growth in the per capita real
disposable income of urban household and the per
capita net income of rural household outpacing the real
GDP growth, supported by the authorities efforts on
strengthening welfare spending, alleviating the social
burden on household and increasing in disposable
income.
While the importance of investment in the economy
is set to be reduced, investment growth is expected to
remain steady as economic rebalancing proceeds. The
authorities are actively restricting investment incentives
in sectors with excess capacity and high pollution
generation. Support to urban and social infrastructure
developments investment continue at good pace, in
order to promote urbanization and enhance people’s
living standards.
China cannot undertake significant and necessary
economic reforms without risking financial and social
disruptions. Reforming the nationwide fiscal
management, improving regulatory and supervisory
oversight, will be key to fix the vulnerabilities in the
government finances and the fiscal institutions. Along
with the liberalization of the interest rates, a more
market-based and liberalized financial system would
achieve better allocation of investment and boost
household capital income. More challenging, credit
bubbles, bad debts and troubled institutions need to be
taken care of, which will help root out the widespread
perception of implicit state guarantees on most loans,
and move to using interest rates as the primary tool of
monetary policy.
Contact
Some subjects that you interested to know more about?
Email: stephane.phetsinorath@biomerieux.com
