Understanding China’s “financial policy”

In most developed countries macroeconomic management is the domain of separate fiscal and monetary policies. In China, the focus is on “financial policy”, a combination of credit, monetary and regulatory policies with powerful direct effects on growth and stability. This “financial policy” has critically shaped the structural development of the economy, fostering particularly state-owned enterprises, heavy industry, and real estate. It has left the economy with a difficult legacy of inefficient credit allocation, bloated shadow banking, and financial systemic risk in the real estate sector. Reforms since 2016 seek to normalize China’s macroeconomic policies but have created severe tensions between the objectives of deleveraging and sufficient growth.

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The shadow of China’s banks

Unlike in the U.S., shadow banking in China is dominated by commercial banks, not securities markets. Regulated banks operate most shadow banking activity, take direct risks, provide implicit guarantees and use non-bank entities to shift assets off their balance sheets. That is why China’s shadow banking is called ‘the shadow of banks’ and why it is such a central factor of systemic risk in this highly leveraged economy. China’s shadow banking has important economic functions for individual savers and smaller enterprises. Outstanding ‘shadow savings’ are estimated at roughly 70% of GDP.

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China’s internal debt overload: a refresher

According to the latest IMF China report credit to non-financial institutions has soared to over 230% of GDP, an increase of 60%-points and a doubling in nominal terms from 2011 to 2016. Credit efficiency, i.e. the benefit of new lending in terms of economic output, has deteriorated markedly. Corporate lending has soared with an outsized allocation to state-owned enterprises, particularly to “zombie” and overcapacity firms. The credit boom has been supported by an abnormally high national savings rate of over 45% of GDP, which is likely to decline going forward. Historically, almost all credit booms that were similar to China’s in size and speed ended in a major downturn or credit crisis.

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The threat from China’s shadow finance

In past years China witnessed a boom in shadow finance, particularly in form of entrusted loans. Banks apparently used shadow credit products in large size to circumvent policy restrictions and bank loan regulations. Regulatory tightening has reined in the proliferation of shadow finance since 2014, but outstanding contracts pose serious systemic risk due to the combination of high default risk and dependence on fragile wholesale funding.

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The China credit risk

The rapid rise of China’s internal debt stock is a global concern. Oxford Economics research shows that non-financial sector debt has soared to 250% of GDP in 2015, due mainly to a very high investment ratio alongside falling corporate profitability. Debt-to-asset ratios look worrisome in problem industries and real estate. Problem loans could be 10-15% of GDP now and might rise to systemically critical levels if the credit boom continues.

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China housing and global base metal prices

China consumes half of the world’s base metal supply. Its housing market is the most metal-intensive large sector. A new quantitative study shows that China housing has been a key determinant of global metal prices during the boom of the 2000s and the bust since 2014. It is a crucial ingredient of forecasting models for directional commodity trading.

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China’s “double impact” on commodity prices

China consumes about one third of the world’s commodities. However, its influence on commodity prices goes beyond that. Chinese institutions are also major users of commodities as collateral. Empirical evidence shows a significant link between domestic lending and global commodity prices, particularly through so-called commodity financing deals.

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The root of China’s financial distortions

China’s financial distortions are rooted in deposit rate controls and implicit loan guarantees. Low remuneration on bank deposits in conjunction with capital controls have long subsidized banks and borrowers. Loan guarantees have spurred excessive lending and neglect of profitability. Reform is perilous as slowing credit would itself undermine credit quality. An IMF model analysis suggests that a removal of loan guarantees would reduce the capital intensity of the economy.

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China fears: updated basic background

Uncertainty over China’s exchange rate regime has accentuated local and global risks. Within China, fears of currency volatility and depreciation have reinforced capital outflows and asset price weakness. Globally, fears of ‘hard landing’ and financial pressure in China have reignited deflation concerns. Public information does not indicate a sharp slowdown or financial distress, but commentators distrust official data of an economy with great systemic vulnerability.

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China’s housing boom: numbers and risks

The surge in housing prices in metropolitan China is a systemic concern. A new paper estimates that price growth has been 8-13% per year from 2003 to 2013, comparable to the 1980s housing boom in Japan. Housing prices have averaged 8 times the annual income of buyers, implying a heavy financial burden. Sustainability relies on ongoing high household income growth and low real interest rates.

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