Abstract
China continues its transition to a sustainable growth path. Rebalancing has progressed on many dimensions, particularly switching from industry to services and from investment to consumption, but less on reining in rapid credit growth. Reforms have advanced impressively across a wide domain, but lagged in some critical areas, and the transition to sustainable growth is proving difficult, with sizable economic and financial volatility. Vulnerabilities are still rising on a dangerous trajectory and fiscal and foreign exchange buffers, while still adequate, are eroding.
China is undertaking a determined transition to a more balanced and sustainable growth trajectory. Its economic growth, albeit moderated from its peak to 6.7 percent in the first half of 2016, is still among the strongest worldwide. CPI growth is well anchored at around 2 percent. The labor market remains robust with 13 million new urban jobs being added in 2015. Seven million more were created during the first half of 2016. These latest developments indicate the strong fundamentals of the real economy. High frequency indicators also saw new signs of revival during the first half of the year. PPI strengthened month-on-month; industrial inventory declined for the first time since 2010; the growth of industrial value-added picked up month-on-month; and sales of housing and automobiles increased markedly.
The rebalancing continued to see concrete progress, with the consumption’s contribution to GDP growth reaching 73 percent, up by 13 percentage points over the last year. The current account surplus stayed below 3 percent of GDP, while capital account outflows moderated, resulting in a slight increase of foreign reserves in June.
It is particularly noteworthy that overcapacity has started to phase out in the coal and steel sectors. The service industry contributed 54 percent of GDP in the first half, up by 2 percentage points over the last year. The manufacturing sector is moving up the value chain, as the growth of the high-tech sector outpaced the industrial average by 70 percent. E-commerce has kept growing at double digits, taking up an increasing market share.
Return to growth potential
China has committed to structural changes aimed at long-term potential rather than short-term growth numbers. It has been widely accepted that the slowdown is a needed transition to the new sustainable growth path. China would not rely on excessive stimulus to pursue unrealistic targets at the cost of the long-term outlook, while appropriate macroeconomic policy response is necessary to ensure a smooth transition. In fact, the credit boom earlier this year has already waned; growth of credit and M2 has been smoothed and moderated, and housing price hikes in Tier 1 cities were largely reined in. Long-term goals of transition and reform have been reassured in the 13th five-year plan.
Looking ahead, China has the potential to sustain growth within a desired range of around 6 to7 percent, sometimes slightly higher than the staff’s baseline assessment. Specifically, the potential for growth is huge on the demand side:
▪The capital/labor ratio, urbanization ratio, and infrastructure (especially in per capita terms) are still far below the AEs’ level, implying large gaps to close, and great potential for catching up; hence, there is lasting demand for investment.
▪Continued migration of the rural population to the urban areas, moving from agricultural sector to more productive sectors, will support robust employment shifting and income convergence with advanced economies.
Such demands would also be supported by strong fundamentals on the supply side:
▪National savings—even though moderating—would remain high by global standards to fuel the lasting investment demand.
▪The manufacturing sector in China—featuring the world’s largest capacity and a complete supply chain—would be able to support the rising demand.
▪The labor force, albeit with less new flows, will generate more human capital, with an increasing share of educated graduates and skilled workers.
▪Both private and public sectors in China are heavily investing in new technologies and “new economies,” reflected by China’s top ranking in new patent applications and registrations and its moving up along the world’s export value chain. Hence, productivity would be boosted.
In view of such strong potential for growth, existing policy space could be tapped to avoid a “hard landing,” thus achieving the potential output. Decisive structural reforms on the supply side would further unlock the potential, notably SOE reforms, streamlining administrative approvals, and enhancing the role of market forces based on broad entry, smooth exit, proper pricing, and effective oversight.
Tackling the high leverage
Based on BIS data (Table 1 below), the overall leverage in China is high but is not particularly outstanding compared to peers. Leverage in China, unlike most AEs, is prominent in the corporate sector, reflecting the dominant banking sector and underdeveloped capital market; but leverage is rather low in the government and in households. Unlike most EMs, 97 percent of leverage in China is financed by domestic savings, with much smaller exposure to currency mismatch, and is, therefore, more of a combined issue of maturity mismatch and soft budget constraint in some SOEs. In addition, debt-to-GDP ratios are not to be compared across countries, because of their high savings rate differential. Debt in stock should be measured against assets in stock rather than against GDP—which is a flow—to reflect more precisely the actual solvency. In fact, the debt-to-asset ratio of China’s industrial corporate sector averaged at 56 percent in June, indicating the higher debt coverage by assets than by GDP.
Total Credit at end-2015, % of GDP, BIS
Total Credit at end-2015, % of GDP, BIS
| Non-financial sector | General government | Households and NPISHs | Non-financial corporations | |
|---|---|---|---|---|
| Total reporting countries | 235.3 | 83.2 | 59.6 | 92.5 |
| Emerging economies | 179.3 | 42.3 | 33.1 | 103.6 |
| Korea | 234.8 | 40.4 | 88.4 | 106.0 |
| Singapore | 247.4 | 104.7 | 60.3 | 82.4 |
| Advanced economies | 268.2 | 107.0 | 75.2 | 86.0 |
| US | 250.6 | 100.1 | 79.2 | 71.2 |
| Japan | 388.2 | 221.0 | 65.9 | 101.3 |
| Euro Area | 266.3 | 104.3 | 59.3 | 102.8 |
| France | 290.2 | 108.8 | 56.5 | 124.9 |
| UK | 265.5 | 105.2 | 87.3 | 73.0 |
| Italy | 275.1 | 153.7 | 42.5 | 79.0 |
Total Credit at end-2015, % of GDP, BIS
| Non-financial sector | General government | Households and NPISHs | Non-financial corporations | |
|---|---|---|---|---|
| Total reporting countries | 235.3 | 83.2 | 59.6 | 92.5 |
| Emerging economies | 179.3 | 42.3 | 33.1 | 103.6 |
| Korea | 234.8 | 40.4 | 88.4 | 106.0 |
| Singapore | 247.4 | 104.7 | 60.3 | 82.4 |
| Advanced economies | 268.2 | 107.0 | 75.2 | 86.0 |
| US | 250.6 | 100.1 | 79.2 | 71.2 |
| Japan | 388.2 | 221.0 | 65.9 | 101.3 |
| Euro Area | 266.3 | 104.3 | 59.3 | 102.8 |
| France | 290.2 | 108.8 | 56.5 | 124.9 |
| UK | 265.5 | 105.2 | 87.3 | 73.0 |
| Italy | 275.1 | 153.7 | 42.5 | 79.0 |
That said, the authorities have paid great attention to the rapid expansion of credit and investment in the 2009-2010 period and more recently the credit in 2015-2016, which, as a counter-cyclical measure, may be understandable but apparently unsustainable. In response, a comprehensive package of deleveraging and restructuring has been worked out. The staff’s proposed solution to the debt stock (including triage, loss recognition, restructuring, and market-based disposal) is helpful and constructive to the authorities’ decisive actions.
Although the staff’s bottom-line approach deserves sufficient attention, we would reiterate that the presumed potential loss of 7 percent of GDP from corporate debt at risk may well be overstated, as the staff’s calculation is based on narrow samples of listed firms, oversimplified measure of insolvency (only by interest coverage), and excessively high loss ratio assumption (higher than Basel III). Furthermore, even at 7 percent of GDP, the potential losses would be adequately absorbed by the strong capital base, sufficient provisioning, and profit margins of the banking system; and, in the worst scenario, would not challenge fiscal debt sustainability.
The authorities are confident that the corporate debt issue can be properly tackled, and the deflation-debt spiral would be curtailed. The 52-month PPI deflation that worsened corporate profitability, raised real interest rates, and threatened corporate debt sustainability, has begun to moderate due to the recent domestic rally of commodity prices and reduction in inventory. Moreover, driven by both structural and cyclical factors, the growth of overall profit margins of industrial enterprises rebounded from last year’s negative figures to 6.4 percent and the debt-to-asset ratio has seen a decline of 0.5 percent in May, which, if persist, would further improve the debt-service capacity of the corporate sector.
Policy outlook
On the monetary front, China will continue its prudent monetary policy, aimed at appropriate liquidity in the market and reasonable growth of credit and total financing. Efforts to achieve the objectives have been largely effective so far. The money market is fairly liquid with interest rates stabilizing at around 2 to 2.5 percent. M2 growth and credit growth have slowed in June to 11.8 percent and 13 percent, respectively—the lowest since last June.
It would be risky to simply deploy a monetary policy index to assess the monetary stance and to draw a conclusion that the current stance is looser than desired. In fact, the prevailing lending rates in the market are still high, particularly in real terms, if adjusted by the PPI deflation. In addition, reasonably low nominal interest rates will also help reduce the debt-service burden and facilitate deleveraging.
On the fiscal front, in view of the apparent fiscal space, the mild expansion of budget deficit is appropriate, given the emphasis on social spending and infrastructure investment that would benefit long-term potential. Furthermore, critical structural reforms on the supply side, including reduction of corporate debt and overcapacity, as well as incentives to encourage innovation and the “new economy,” also require fiscal support. In this context, caution is warranted in interpreting and using the “augmented” deficit in comparison to other countries. This is because a large part of the local government’s liability corresponds to assets that will generate financial and economic return, rather than general expenditures. Historical sample records show that the payment ratio for the local government’s contingent liability has been only 20 percent. We believe the increased transparency, the hardened budget constraint, and the ongoing standardization of local government finance will improve the quality and efficiency of their spending. After all, even the very unlikely “upper bound” of the “augmented” debt—74 percent of GDP—is still low by international standards.
On the revenue side, the full adoption of VAT in the service sector would entail an estimated tax reduction of RMB 600 billion. The intended fiscal reforms—especially a new fiscal federalism system to better match local governments’ revenue with their spending commitments and a more direct tax-based system with broader tax base, greater progressiveness, and less procyclicality—are already in the pipeline. These are expected to improve revenue prospects and further enhance fiscal soundness.
On the financial front, the overall banking sector is adequately capitalized, well provisioned, and properly supervised in accordance with the Basel III, demonstrating strong buffer and great resilience to potential risks. The authorities have made substantial efforts to implement FSAP recommendations, especially those of high priorities. In view of concerns on the rising NPLs and booming nonbank financing, the authorities have kept close watch of the evolving risks and the interlinkages across the entire financial system, with committed efforts in the early warning of potential risks, the mitigation of emerging risks, and a thorough stocktaking of the actual risk profile of financial institutions. Toward this end, the authorities have been cooperating with the Fund and the Bank on undertaking a full scope update of FSAP. A macroprudential framework has been put in place and coordination among regulatory authorities, as well as communications, have been enhanced so as to guard against systemic risks and better guide public expectations.