Clouds over China’s Economy: A Challenge for the New Leadership

Late in June this year China’s interbank market (in which banks borrow and lend short-term funds as required for liquidity) experienced a sudden crunch. An overall shortage of funds caused interest rates to spike, and it was rumored that some banks had failed to raise the funds they needed. In most countries such a development would be a sign that a financial panic was in the offing. The crunch ended quickly, but since then observers both in China and abroad have been expressing increased concern about the prospects for the country’s economy.

The Growth of Shadow Banking

The severe shortage of funds was due to a combination of factors. Some were seasonal, such as the approach of a tax-payment deadline. Others were policy-related, such as banks’ increased demand for funds in the face of the authorities’ tightening of the monetary policy reins, along with the sudden drying up of the inflow of hot money disguised as the proceeds of trade transactions in the face of a clampdown on these illegal maneuvers.

The crunch in the interbank market highlighted two major developments. The first is the rapid growth of “shadow banking”—the raising of funds from sources other than conventional bank lending. Banks themselves have become heavily involved in supporting this unconventional funding, and this has contributed to the sharp rise in their demand for funds. The second is the shift in the behavior of the monetary authorities in the face of the shortage of short-term funds in the market. Previously they provided liquidity to cover such shortages, but this time they did not. It is said that the authorities were deliberately seeking to discipline those banks that were participating too enthusiastically in the high-risk shadow banking sector.

The volume of funding provided through shadow banking surged over the course of the past year. The specific funding methods vary, but the common characteristic is that short-term funds are provided at high interest rates—at least 50% higher than the standard rate applied to a bank loan.

Why have borrowers increasingly turned to this costly form of funding? The sharp increase in use of shadow banking is a result of factors related to irregularities in the Chinese economy. The policy of using expanded investment as the locomotive for economic growth, which the government had been following since 2009, reached an impasse, and negative effects have emerged on various fronts.

Serious Aftereffects from Extreme Monetary Relaxation

When the bankruptcy of Lehman Brothers in September 2008 was followed by a global economic crisis, the Chinese government responded with a massive program of investment, amounting to some 4 trillion yuan nationwide, along with a loosening of monetary policy on an unprecedented scale. Thanks to this stimulus the Chinese economy quickly bounced back from its downturn. But the serious aftereffects of these bold policy moves have recently been growing increasingly visible.

For one thing, the stimulus from monetary relaxation led to a profusion of unproductive investments around the country, resulting in a serious excess of investment in manufacturing. The state-owned enterprises that undertook large-scale outlays and the local governments that grabbed the opportunity to build infrastructure have found themselves stuck with increased debts; meanwhile, profit levels have declined and cash flow problems have emerged. Second, loose money has led to rises not just in real estate prices but also in consumer prices. According to official statistics the rate of inflation is less than 5%, but in fact prices are climbing by more than 10% a year.

The rapid growth of shadow banking is a result of these aftereffects. Enterprises that took out large loans from banks several years ago to fund huge investments are now starting to reach their repayment deadlines, but their unproductive investments have not generated income, and the only way they can repay their loans is by rolling over the debt.

The unprecedented monetary relaxation has caused China’s money supply to balloon to 1.9 times nominal gross domestic product. By this measure China should be more awash in funds than anyplace else in the world. So at first sight it seems paradoxical that many enterprises are borrowing money at high interest rates through the shadow banking system. The reason for this phenomenon is that the large number of outstanding loans being refinanced is leaving the conventional banking sector short of the repayment inflows that would ordinarily be used to fund new lending. The contraction of the volume of funds available for new loans has resulted in extreme tightness of funds on a localized basis.

Meanwhile, rising consumer prices have made savers loath to leave their money in regular bank accounts paying low interest rates, and institutions involved in the shadow banking sector have been attracting their funds by touting the higher interest rates of their “wealth management products.” So the flow of funds within the Chinese economy has departed from its normal course.

The Need to Review Both Economic and Foreign Policy

Three months since its official launch, the new administration of President Xi Jinping has become increasingly alarmed at the seriousness of the situation, and the leadership has apparently decided to shift away from the previous policy of relying on investment to drive the economy, even if this means lower growth rates. This is the proper choice for the sake of achieving steady, sustained economic expansion.

This shift, however, will be accompanied by serious pain. Roughly half of the 8%–10% growth that China has achieved in recent years has come from increased investment. If the authorities slam too hard on the investment and monetary policy brakes, the growth rate is liable to drop close to zero. The government will need to adjust its policy gradually over the course of several years, but as it does so, the task of managing the economy will become extremely difficult.

Even if the government manages to pull out of the tunnel of aftereffects from excessive investment, it will face the inexorable onset of a demographic shift to fewer births and an aging population starting in the 2020s. The finances of China’s central government are much healthier than those of other major countries, and so the authorities will have leeway to use public funds to alleviate various problems, including the clearing away of bad debts. But slower economic growth will probably cause the state’s debt ratio to climb sharply.

The surge of economic growth in China from 2009 on generated euphoric sentiment, and this was accompanied by an increasingly assertive foreign policy with respect to what Beijing identifies as the country’s “core interests.” The sharp deceleration of the economy has caused the Chinese to awake from their euphoria, and they find themselves confronting a situation much more severe than four years ago. China needs to completely rethink both its national objectives and its external relations.

(Originally written in Japanese on July 17, 2013)

Photo: The sun sets behind the Shanghai skyline.