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China’s Deleveraging Overshadows Trade War

November 16, 2018
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As Washington and Beijing edged closer toward a trade confrontation in June, the trade imbalance between the United States and China reached a record $28.97 billion.[1]

A rush of purchases made by U.S. importers before the July 6 tariff deadline was partially to blame for the growing bilateral surplus. Overshadowed in the data, however, were signs that President Xi Jinping’s financial tightening and deleveraging campaigns were beginning to take a toll.

Xi has cited financial risks as “a critical battle” for the future. Over the past year, Xi has overseen a crackdown on risky lending and hidden debt, the rapid increase of which is one of the main drags on his goal of “quality growth.”  As a result, China has seen an increase in funding costs, slowing consumption, and weaker industrial output.[2] June data showed imports were decreasing not just from the United States, but around the world.

Beijing has carefully managed a gradual slowdown of the Chinese economy for the better part of the last decade, buoyed at times by aggressive stimulus measures. But after years of easy credit and breakneck growth, the Chinese leadership faces mounting corporate and local government defaults. If unaddressed, debt could pose a long-term threat to the Chinese economy, whose continuous growth has underpinned the legitimacy of the Communist Party since preeminent leader Deng Xiaoping launched his program of reform and opening forty years ago. This may explain why Xi, even in the facing of faltering growth and a trade confrontation, appears to be applying stimulus more selectively than in past downturns.

Few countries manage to pull off soft landings, and trade conflict makes the task even trickier. The announcement by China’s central bank that it would cut reserve-requirement ratios in June to provide limited support to banks ahead of expected U.S. tariffs underscored these challenges. It is no secret that Chinese policymakers have struggled to deal with Donald Trump; when Beijing’s “tit for tat” response measures failed to get the United States to back down, it shifted to the defensive by ramping up broad expansionary policies.

How the Chinese leadership navigates tensions between the twin goals of stable economic growth and debt reduction will have global significance. China is the world’s largest exporter and manufacturer. It accounts for more than a third of global economic growth. China’s monetary tightening has meant slower growth in China and the world economy. Its slowdown is already showing up in weaker eurozone growth and a slide in South Korean exports. This is a test of China’s readiness and willingness to be a global economic leader, not just a big economy.

Ultimately, China’s tough line on deleveraging is good for the economy’s long-term sustainable growth. Although China’s economy can seem like a juggernaut, few things would threaten economic and, therefore, political stability as much as a banking crisis. Ridding the financial system of its debt overhang and reforming the way it allocates capital will change the way the economy operates and promote efficiency, as well as new industries. With a slower economic outlook in the next 12-18 months, investors need to prepare accordingly while China should expand reforms and further open its economy to foreign investment.

Remedial Steps

Reining in Debt Levels: China’s addiction to credit – which can be traced back to the global economic crisis in 2008, now threatens growth. China has tolerated rising debt in order to sustain GDP growth rates that are sufficient to maintain full employment and rising living standards for Chinese citizens, outcomes that help bring legitimacy to the Communist Party. But the pace of debt accumulation may no longer be sustainable. Moreover, the money is increasingly flowing through channels outside the regulated banking system, leaving China vulnerable.

In 2017, Moody’s cut China’s debt rating, its first downgrade since the Tiananmen Square protests in 1989. China’s debt problems are increasingly drawing comparisons to Japan, where, a credit-backed boom burst in the early 1990s. The Japanese government’s subsequent reluctance to deal with indebted companies has contributed to decades of slow growth.  The Chinese government would like to avoid a similar fate, but it will require painful measures.

Over the past eighteen months, Chinese policymakers have taken monetary policy measures to crackdown on risky lending and make progress in reining in its debt levels (see Chart 1). Flows into the “shadow banking” system have been reeled in, interest rates have been raised, and regulatory oversight has been strengthened. The aim has been to force companies and local governments to repay existing loans, borrow less, and write off bad debts in order to create a more stable financial system. Some initial progress has been made, as evidenced by a stabilizing overall ratio of debt to GDP. But it’s too soon to stop (see Chart 2).

                  

Source: IMF annual assessment of China’s economy, page 8: https://www.imf.org/en/Publications/CR/Issues/2018/07/25/Peoples-Republic-of-China-2018-Article-IV-Consultation-Press-Release-Staff-Report-Staff-46121)

Raising Interest Rates: The People’s Bank of China (PBOC) took aggressive action to discourage risky borrowing by raising interest rates on one-year risk-free loans by 70 basis points in the fourth quarter of 2017—an increase nearly three times that of any hike by the U.S. Federal Reserve in its current cycle. As a result of these interest rate hikes, spending and investment declined precipitously in the first half of 2018, which weakened demand and slowed inflation. Even as the PBOC has cut interest rates in 2018, the rate of decline for inflation has outpaced interest rate cuts, meaning that the real cost of borrowing actually increased during the first six months of the year. Furthermore, after interest rates peaked at the end of 2017, China saw an increase in capital inflows, which led to currency appreciation in 2018 and was responsible for China’s first current account deficit in 20 years.

Tightening Regulations on Shadow Banking: As credit has become increasingly scarce and borrowers look to other sources for lending, the government has stepped up efforts to increase regulation of China’s $10 trillion shadow banking sector since late 2017. These efforts have proven successful, as they have deterred banks from taking on risky investments. Shadow banking assets as a proportion of GDP – which had more doubled from 39 percent in 2011 to 87 percent in 2016 – reversed the recent trend and dropped to 79 percent in 2017.[3] Efforts to reduce risky lending practices are ongoing, but the early results of increased regulation have been promising.

Limiting Local Government Borrowing: China has taken action to defuse local debt risks by imposing increasingly stringent regulations on local government off-budget borrowing and eliminating regulatory loopholes. In order to skirt regulations on off-budget borrowing, local authorities have often resorted to means such as establishing public-private partnerships and government service procurement contracts to secure funding. Local governments have previously been heavily reliant on off-budget borrowing channels as the primary sources of funds for local investment projects. Eliminating off-budget borrowing channels has significantly impacted on-budget expenditures, resulting in a sharp decline in infrastructure development – which has been mostly funded by local governments – in the first half of 2018.

Three Critical Battles

Two major political conferences over the past year – the 19th Party Congress, where Xi abolished term limits for the Chinese presidency, and the subsequent Two Sessions – have served to solidify Xi’s authority. First, at the 19th Party Congress, Xi called on China’s top leadership to redouble efforts to re-calibrate China’s economy by urging the Party to prioritize “higher-quality” growth over faster growth. In his work report, Xi also cited curbing financial risks as first on a list of China’s “three critical battles” for the future, followed by poverty reduction and controlling pollution. He indicated a further departure from the government’s annual growth targets by deliberately omitting any mention of the GDP target during his 3½-hour speech.[4] China took swift action after the conclusion of the Congress, announcing new deleveraging reforms designed to clamp down on shadow banking, tighten control on wealth management products, rein in local government debt, and limit real estate lending.[5]

Appointments made at the two major conferences allowed Xi to select personnel who will prioritize quality growth. Among those appointed by Xi, none saw a more rapid rise than Xi’s top economic advisor, Liu He. In March, Liu was confirmed as one of four vice-premiers and assigned a broad portfolio, which overshadowed that of Premier Li Keqiang. Liu has also been appointed to lead the newly-established Financial Stability and Development Commission (FSDC), which is expected to help improve supervision and coordination among regulators and the central bank. According to University of California at San Diego economist, Barry Naughton, Liu He has a dominance of economic policy that can only be compared to Zhu Rongji’s dominance when he was vice premier from 1991 to 1998.[6]

Liu’s meteoric rise over the past year offers a sign that Xi is committed to fixing a financial system that has become over-dependent on risky borrowing to boost economic growth. Liu has been an advocate of the idea that China’s debt-driven model of economic growth carries with it not only financial risk, but a more fundamental security issue. Liu is widely regarded as the anonymous “authoritative person” who gave an interview in 2016 to People’s Daily that warned against relying on loose monetary policy to help accelerate economic growth.

Economic Slowdown Concerns

Despite the strong commitment by senior Chinese leadership to undertake the necessary steps to ensure the long-term health of the Chinese economy, there is growing sentiment in China that the pace of the slowdown has been too fast. Moreover, President Trump’s trade rhetoric and tariff actions have caused public criticism of China’s promoting of its Made in China 2025 plan and technological advancements. As a result, Chinese policymakers have tried to stabilize expectations and tone down their rhetoric.

A similar backlash and policy recalibration has been seen with the Belt and Road Initiative (BRI). Chinese State-Owned Enterprises (SOEs) that were previously unrestrained as they amassed large amounts of debt are now subject to more limited spending capacity as a result of mandates to reduce debt-to-asset ratios. BRI investment deals that are deemed too risky may be unwound, while the pace of new investments may fall off. Waning enthusiasm for the BRI – as evidenced by a 36 percent drop in BRI-related investment commitments and construction contracts in Southeast Asia during the first half of 2018 – coupled with China shifting its focus to managing its domestic economy, could lead to more favorable terms for neighboring countries negotiating BRI-related deals. These challenges, along with the cancellation of BRI projects in Malaysia and issues encountered on other BRI projects, could present opportunities for China to reassess project evaluation and implementation, leading to a more sustainable vision for the BRI.

In recent months, financial regulators have delayed the implementation of rules to curtail risky lending by banks and other institutions out of concern that the regulations would choke off a critical source of funding and rattle financial markets already shaken by worries over trade and the economy. China’s State Council also has reversed course on pushing local governments to limit spending and has instead recently taken steps to urge them to speed up previously-approved investment projects in an effort to jump-start growth.[7]

In April, Xi chaired a Politburo meeting that reiterated China will maintain a proactive fiscal policy, and will keep monetary policy prudent and neutral, while also adding a new point that China will boost domestic demand to ensure the stability of the economy.[8][9] This meeting occurred on the heels of an unexpected announcement by the central bank that it was cutting the amount of cash that banks must keep in reserves, raising concerns among investors about the risks to China’s economic growth outlook and whether Beijing is backsliding on its promise to reduce debts.[10] A separate politburo meeting in late July called for top leadership to ensure “stable employment, stable finance, stable foreign trade, stable foreign investment, stable investment and stable expectation.”[11] On August 2, the Financial Stability and Development Commission emphasized that de-risking and de-leveraging would continue, but shifted the focus to law enforcement and regulatory control.

Trump Vetoes

Escalating trade tensions with the U.S. have blindsided Chinese leaders, according to some experts,[12] and complicated China’s efforts to carry out measures to deleverage its economy. The Chinese leadership believed Trump, as a businessman, would be transactional. They believed that by cultivating guanxi, or personal connections, with his family they would be able to make “deals.” But, in the Chinese view, Trump has twice throttled negotiations by rejecting deals that his negotiators had reached and brought back to the capital: first, after Commerce Secretary Ross and Politburo Standing Committee member, Wang Yang, achieved agreement on modest openings to China’s economy at the U.S.-China Comprehensive Economic Dialogue in July 2017; and later, after Vice Premier Liu He visited Washington, after already having been stood up by President Trump, and committed that China would increase purchases of U.S. goods and reduce the bilateral trade deficit. These experiences have discredited key Chinese policymakers and disempowered Trump’s trade team. They have also convinced the Chinese that the United States has no coherent set of objectives or bottom line, and that President Trump is the only one who can make the final decision.

Since these failures, China’s macroeconomic policy tools – monetary, fiscal and exchange rate policy – have all become more expansionary, giving China a relatively small boost for the next stage of the trade wars.

In June, the central bank announced a decision to cut reserve requirements that would take effect on July 5 – one day before the first round of tariffs levied by the Trump administration took effect. By cutting reserve requirements, the central bank hoped to help strengthen credit flows to small firms and boost growth to offset the negative impacts of the looming trade war. The cuts provided RMB 500 billion (USD 77 billion) to China’s five large state banks and 12 national joint-stock commercial banks to allow lenders to conduct debt-for-equity swaps, which can reduce debt and help spruce up balance sheets. Another RMB 200 billion (USD 31 billion) was released by the cuts to provide funding for mid-sized and small banks to increase lending to credit-strapped small businesses.[13] Finally, the RMB depreciated by 7 percent in June and July, making Chinese exports cheaper and modestly boosting the economy.

Despite these challenges, China’s top leadership maintains that policy support measures such as reserve cuts and cash injections into the banking system are limited actions providing targeted support, and do not signal that it is reversing course on its deleveraging campaign. Nevertheless, senior Chinese leadership faces a tough task in trying to guide China’s economy to a soft landing in the face of an intensifying trade war. As the world’s second largest economy, the effects of China’s decisions in managing its economy extend far beyond its borders.

A prolonged trade war between the world’s two largest economies would mark an important new chapter in the economic and strategic relationship between the U.S. and China. In the years after China’s accession to the WTO in 2001, the two economies have become increasingly interdependent and intertwined as a result of burgeoning trade of goods and services, along with a rapid rise in cross-border investment. The Trump administration, however, has taken aggressive actions towards China, increasingly promoting the view that relations between the two countries amount to a zero-sum competition for global dominance. The widespread view now in China is that U.S. tariffs are the first step of a broader U.S. containment strategy and new Cold War. There is speculation that U.S. policymakers are rethinking the strategic benefits of U.S.-China economic interdependence. If these ideas prevail, the bilateral relationship could fundamentally be redefined for the worse, with broad negative implications for business, governments, and ordinary citizens.

Outlook for CEOs

While much attention will remain focused on the trade war between the United States and China, the key issue for companies with long-term business strategies in China to understand is much more fundamental: China remains much less open to trade and foreign investment than most countries—even developing ones. This is true across the board—whether examining tariffs, regulation, or market access rules.  China’s industrial policy allows its policymakers to disadvantage foreign firms. Government intervention continues to be pervasive. Chinese policy has remained non-transparent and biased.

Trade war aside, foreign firms must continue to press Chinese leaders to adopt more dramatic reforms and the opening of its economy. Despite repeatedly declaring its intention to do so, China has not followed through on making its business environment more open and fair.

If China follows through on fighting this ‘critical battle’ to wean itself off credit-spurred growth, the Chinese economy is likely to see slower growth rates over the next 12-18 months. This slowdown will have implications for the global economy as well, which is likely to see slower growth in the second half of 2018 and into 2019. The upside to this is that successfully deleveraging China’s economy will be good for its long-term sustainable growth. Ridding the financial system of its debt overhang and reforming the way it allocates capital will also change the way the economy operates and promote efficiency, as well as new industries.

Xi Jinping remains firmly in control, despite rumors this past summer of simmering dissent within the Communist Party and criticism of his handling of the U.S.-China relationship. Xi recognizes that few things would pose a greater threat to economic and political stability than a banking crisis. An all-out trade war would increase the cost of credit tightening. Nevertheless, Xi has to a large extent shielded himself against a backlash towards his handling of the economy, as he used a sweeping anti-corruption campaign to remove his enemies and used the power he consolidated to line the politburo with his allies at the 19th Party Congress.  He is also likely to save his policy ammunition for the fourth quarter after even larger U.S. tariffs could take effect.

China is not an easy place for foreign firms to do business. Trade tensions and slowing growth together create a complex business environment for multinational companies operating in China. Nevertheless, it remains an indispensable market. As such, CEOs should seek out opportunities to travel to China to both demonstrate their commitment to the Chinese market and gain a greater sense of the situation on the ground.

CEOs should seek to participate in key Chinese government-sponsored conferences and dialogues such as the Bo’ao Forum for Asia, China Development Forum and World Economic Forum’s Annual Meeting of the New Champions – all of which provide excellent opportunities to engage with important stakeholders. Stakeholder engagement in China, however, should not be limited to meetings with government officials. Frequent engagement with leaders in business, academia, and media can help cultivate relationships that enable CEOs to gain a greater sense of the business environment from the perspectives of influencers who impact policy and decision-making in their respective industries.

Finally, it remains critically important that foreign companies demonstrate alignment with the leadership’s objectives. Efforts to achieve the objectives outlined in the 13th Five Year Plan (2016 to 2020) are ongoing, and Xi’s work report at the 19th Party Congress provides an overview of China’s major objectives for the next 30 years and beyond. Multinational companies with long-term growth strategies in China must possess a comprehensive understanding of Xi’s vision for China and should seek out opportunities to support these goals.