Twelve months ago, capital was still haemorrhaging out of China, draining the foreign currency reserves and dragging the renminbi down. Today, China’s markets seem becalmed. Gentle but sustained credit and monetary policy tightening has yielded the economic stability that the government needed ahead of the crucial 19th Party Congress in coming months.
The real test, though, is whether the newfound political acceptance of tightening, and slowing economic growth, will work and endure. Whether they do or don’t, markets are not discounting the implicit discontinuities.
The authorities have acted in three ways over the past year. First, they tightened capital controls, foreign exchange payments abroad and Chinese overseas investment flows to stabilise the decline in reserves. Second, all the main regulatory agencies acted for the first time in concerted fashion to contain excessive risk taking and reduce the effect of some of the more egregious forms of financial indiscipline; for example, by insurance companies. Third, short-term interest rates rose steadily until about May this year by between 40 and 60 basis points, with bond yields rising nearly 100 basis points.
The relentless increase in China’s ratio of debt to gross domestic product and deterioration in financial system balance sheets have levelled off monetarily thanks to the attempts to control growth of assets held off-balance sheet and booming interbank business. The renminbi, helped by a fortuitously weak US dollar, has strengthened back to where it was a year ago.
The tightening phase, though, measured by the rise in policy and market interest rates, is quite tame compared with other such cycles in the past 10-15 years. The regulatory crackdown is new, but both monetary and credit tightening have been permitted under the most propitious of economic conditions. When the latter change, there is no reason to doubt that policy will be eased again in keeping with precedent.
The cyclical upswing, not evident in the seemingly manicured GDP figures, flowed from significant policy easing in 2015/16 and has been led by investment and activity in real estate and in infrastructure. This was the antithesis of the economic rebalancing that China needs, but more than sufficient to keep the economic wheels spinning ahead of the Party Congress, and a timely tonic for the global economy as evidenced by the strong rally in the prices of industrial commodities, especially iron ore, nickel, aluminium, and copper.
Yet, as policy tightening is gaining traction, real estate and the economy are starting to falter and July’s economic numbers marked a significant break from activity in the first half of the year. Exports and imports lost momentum. Industrial production, retail and car sales, and investment especially in real estate and manufacturing were all materially weaker. Housing sales and starts have suffered from the accumulation of purchase restrictions and tighter mortgage lending. Broad indicators of credit growth rose in July, but the trend since the spring is softer. More evidence of slower economic growth is likely to emerge in coming months.
The question as to whether policy tightening will endure is important because a real deleveraging of the financial system, state enterprises and the potpourri of local and provincial government borrowing entities will have a profound impact and impose severe costs on the Chinese real estate sector specifically, and economic growth and employment more generally.
In a proper deleveraging, bad lenders and borrowers would be wound up and sold off. Liquidity would be carefully targeted, and a greater incidence of bankruptcies and an extensive reduction in balance sheet liabilities among financial firms would all signify a material change. The 6.5 per cent growth target would probably be abandoned. Yet, governments tend to do these things under duress, not out of choice.
Twelve months from now, the concentration of power around China’s president Xi Jinping is more likely to have stifled than stimulated reform initiatives. A more subdued economy will have led to a renewed easing of policy but with diminishing effectiveness. The risk of a financial system funding shock, highlighted most recently by the IMF in its Article IV report, will be more advanced.
We will probably have seen the first skirmishes in Trump’s economic war with China. These and other discontinuities are likely to return China to the cross-hairs of global markets before too long. Lower lows for the renminbi and higher volatility in other financial asset and commodity markets are most likely.
George Magnus is an associate at Oxford university’s China Centre, and former chief economist at UBS