China’s Economy

September 2014 Written by Stéphane PHETSINORATH

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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.

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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.

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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

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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 GDP16

, 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.

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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.

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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.

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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.

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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.

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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

201840

.

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.

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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.

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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.

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“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

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