Focus on financial risk puts China on a more sustainable path
The leadership seems to accept slower growth as price of moderate credit expansión
by: Nicholas Lardy
After years of hyper rapid credit growth, China’s leadership now has a laser-like focus on reducing financial risk. Not so long ago this issue was met with official silence. Since late 2016, President Xi Jinping has devoted half a dozen speeches to the topic.
Such top-level attention has already led to substantial policy changes. The head of the insurance regulator, which had allowed companies to sell short-term life policies to finance illiquid, long-term investments, was fired and more restrictive policies have been strictly implemented. New aggressive leadership took over at the bank regulator, which almost immediately issued new rules to curtail regulatory arbitrage by banks and began to investigate excessive lending to a small number of companies that were making large foreign acquisitions.
The central bank took steps to raise short-term interest rates, including importantly in the interbank market. Finally, the state council, China’s cabinet, last month established a Financial Stability and Development Commission to better co-ordinate supervision among the various financial regulators.
Hand in hand with these developments, credit expansion in China has moderated significantly over recent quarters.
Conventional wisdom says that tightening financial conditions and the tailing off of the recent resurgence of enterprise profits will slow growth — something that runs counter to official policy. In response, the authorities, determined to meet their longstanding goal of doubling real gross domestic product in the decade to 2020, will not consolidate the budget deficit and push appropriate structural reforms, such as the down-sizing of lossmaking state enterprises. Rather they will simply continue to run large deficits and resume the previous breakneck pace of credit expansion in order to fuel growth.
The result, according to the International Monetary Fund, will be a further surge in both public and corporate debt. On the latter, the IMF anticipates that the ratio of domestic credit to GDP will rise to almost 300 per cent of GDP by 2022 — a level that elsewhere in the world has been associated with either sharp slowdowns in growth, when the problem of excess leverage is eventually addressed, or financial crises, if the problem is ignored.
This analysis overlooks several factors. First, China’s leadership has clearly elevated the priority of reducing financial risks relative to maximising economic growth. They seem prepared to accept somewhat slower economic growth and even some increase in financial stress as the price of more moderate credit growth.
Second, although growth has slowed since the global financial crisis, China is well within striking distance of doubling its real GDP in a decade. Doubling in 10 years requires a compound annual growth rate of 7.2 per cent. In the six years to the end of 2016 China’s GDP expanded at an average rate of 8.1 per cent in real terms. Growth this year will quite likely at least match last year’s 6.7 per cent, so average annual growth of 6.3 per cent in the next three years will put the economy over the line.
Third, China’s growth is becoming less dependent on credit-fuelled investment. Consumption growth has come to the fore, contributing two-thirds of economic expansion in both 2015 and 2016 and over three-fifths in the first half of this year.
For households, consumption growth has been facilitated by the expansion of wages, interest and business income, and government transfers. Thus, disposable income has been growing more rapidly than GDP since 2013. That trend seems certain to continue. Wages are likely to continue to grow relatively rapidly, given the ongoing shrinking of the working-age population and the emergence of the more labour-intensive service sector. And the government seems likely to further boost pension payments and other types of transfers.
So a 6.3 per cent pace of growth should not require credit expansion at the rate of recent years. The authorities should sustain the more moderate expansion of credit, which is consistent with the policy of reducing financial risk and putting China’s growth on a more sustainable path.
The writer is a senior fellow at the Peterson Institute
But given how calmly markets have traded in recent months, it’s perhaps understandable why market observers might have lost perspective.
A Sunday piece in the New York Times supplies the numbers to illustrate just how tranquil the stock market has been in recent months, even against a backdrop of war talk out of North Korea and the never-ending infighting in the White House.
Jeff Sommer, a veteran editor with the Times, writes that the U.S. stock market has moved in its tightest range since 1965, though the small daily movements have fortunately trended to the upside.
Sommer quotes Ryan Detrick, a senior market strategist for LPL Financial, who has found that the Standard & Poor’s 500 has not had a 5% decline, from peak to trough, since June 28, 2016. “That sell-off, 6.1 percent over several days, occurred after Britain’s surprise vote on June 23, 2016, to leave the European Union,” he adds.
Moreover, other measurements supplied by LPL Financial’s Detrick show the same pattern. “For the three weeks through Aug. 10, the closing levels of the S&P 500 never had a daily swing of more than 0.3%, never happened before in the history of the S.&P. 500.” And for 2017 so far, the average daily trading range has been 0.55%, the lowest ever.
But then Sommer’s piece moves quickly from the factual to the speculative. His main point is that the stock market’s period of tranquility is “bound to end.”
To which anyone might conclude, “Well, of course, it’s bound to end.” The question is: how soon?
Sommer, like all other market observers, doesn’t have the answers, nor should he. In fact, he’s profoundly unsure just where markets are heading, as this bit of writing makes clear.
“One of these days, these various streaks will end. A big stock market decline could well precede and predict a recession,” Sommer concludes. “But barring a disastrous geopolitical, economic or financial shock — there are plenty of possibilities, take your pick — it is likely that both the bull market and the economic recovery will keep grinding on for a while. But don’t count on it. We are pushing our luck. Even if you believe in magic, the markets rarely stay calm and buoyant for such an exceedingly long time.”
While no one should turn to journalists for forecasting advice, the same applies to highly-celebrated hedge-fund managers.
In his latest written commentary, Ray Dalio, the chairman and chief investment officer of Bridgewater Associates, puts investing aside to mount a political soapbox.
Dalio asserts that “politics will probably play a greater role in affecting markets than we have experienced any time before in our lifetimes but in a manner that is broadly similar to 1937.”
Dalio writes that “history has shown that democracies are healthy when the principles that bind people are stronger than those that divide them, when the rule of law governs disputes, and when compromises are made for the good of the whole—and that democracies are threatened when the principles that divide people are more strongly held than those that bind them and when divided people are more inclined to fight than work to resolve their differences.
Conflicts have now intensified to the point that fighting to the death is probably more likely than reconciliation.”
He adds: “While I see no important economic risks on the horizon, I am concerned about growing internal and external conflict leading to impaired government efficiency (e.g. inabilities to pass legislation and set policies) and other conflicts.”
The problem is that Dalio’s political essay leaves investors to guess what the current state of affairs might mean for them.
Does political instability trump an economy with “no important” economic risks?
Dalio doesn’t answer this question, so we might have to watch how it plays out in real life.
