China: Growth versus Reform

In spite of a period of pronounced geopolitical risks, developed economies are experiencing modest growth, and growth in developing economies is stabilizing.


The Chinese government faces a dilemma: It wants to maintain economic growth, which entails boosting credit market activity, while implementing long-term reforms that require restraining credit growth.


The third quarter edition of the Global Economic Outlook offers timely insights from Deloitte Research economists about the United States, the Eurozone, China, Japan, India, Russia, Brazil, and the United Kingdom.

By Dr. Ira Kalish, Chief global economist of Deloitte Touche Tohmatsu Limited

CHINA’S economy continues to show signs of weakness, although there are also signs of stabilization at a relatively modest level of growth. This is creating a dilemma for the government. On the one hand, it wants to maintain economic growth at a level that avoids social disruption. In the short term, this entails boosting credit market activity. On the other hand, the government wants to implement long-term reforms aimed at creating sustainable growth that does not rely on excessive credit growth. That means restraining the growth of credit. What should it do? Currently the government is doing a little bit of both.

Easing restrictions

First, in order to maintain growth, the government is loosening the reins on banks in order to stimulate more lending by banks to the private sector. China’s banking regulator has said that it will, once again, reduce the   amount of reserves that some banks are required to hold with the central bank. This would be the third reduction in the required reserve ratio in the past three months. The idea is to stimulate more lending to small businesses and first-time home buyers at a time when the economy is slowing more than anticipated. This action is meant to boost credit market activity in general. Yet it follows other measures designed to rein in credit market activity. Thus, this measure is meant to boost formal bank lending, while the previous measures were meant to cut off-balance-sheet, or shadow banking, activity.
The latest data suggests that credit market activity is accelerating. Bank lending in China increased strongly in  May, up 12.4 percent from April. The outstanding stock of bank loans increased 13.9 percent from a year earlier. The broad money supply increased 13.4 percent from a year earlier, reflecting a slight loosening of monetary policy. All of these figures are higher than investors had expected. The government has been keen to stop the economic slowdown that has been under way this year, and allowing faster growth of credit is one way to do this. However, the risk remains that excessive credit growth will cause other problems down the road.
Indeed, the World Bank recently criticized China’s current policy of boosting credit as detrimental to reform.1 It said that boosting credit market activity “may perpetuate China’s traditional growth model that relies on   government led investment fueled by credit expansion.” The World Bank said that “a policy focus on meeting growth targets could distract from pushing through the structural reforms intended to put long-term growth on a more stable footing. Delays in implementing coherent reforms could perpetuate resource misallocation, undermine the health of the banking system, threaten the debt sustainability of local governments, and increase the fiscal costs of reform.” Meanwhile, President Xi Jinping said that fiscal and other reforms are urgently needed, but they must be carefully planned.2 He urged action but gave little detail. He alluded to the political difficulties in implementing reforms.

Imposing restrictions

Actually, the government has taken action designed to avoid excessive credit growth. The Chinese government has ordered banks to restrict their interbank lending, mandating that such lending may not exceed one-third of a bank’s liabilities nor exceed half of a bank’s tier 1 capital. The idea is to put limits on the expansion of the shadow banking system, which relies heavily on interbank lending for short-term finance. The volume of interbank lending has increased dramatically in recent years. The problem is that, although this action will help to quell the growth of risky shadow banking, it may also have the effect of slowing credit growth and, therefore, growth of the economy. The central bank reports that, at the end of 2013, the outstanding volume of interbank loans was 21.5 trillion yuan ($3.45 trillion), compared with 6.2 trillion yuan in 2009. 
Interestingly, the share of total credit growth attributable to bank lending increased from 50 percent in April to 62.2 percent in May. This means that the lion’s share of credit growth took place through traditional banking channels, rather than through the shadow banking system. This presumably reflects the intention of government policymakers. If so, it also reflects the fact that the government is eager to restrain the shadow banking system, which likely harbors most of the risk to the financial sector.
One problem is that efforts to suppress shadow banking have also created problems for formal banking. Indeed, for the 10th consecutive quarter, the volume of defaults on Chinese bank loans has increased. In the first quarter of 2014, the volume of bad loans increased the most since 2005. Nonperforming bank loans reached their  highest percentage of total loans (1.04 percent) since September 2008. Still, it is worth recalling that nonperforming loans were 15 percent of the total in 2005. Yet the recent figures only reflect the amount on the banks’ balance sheets. The large banks have considerable informal exposure to off-balance-sheet trust companies that have loaned heavily to often-questionable projects. This shadow banking system is where the trouble lies. The true exposure of the banks to bad loans is probably much higher than the reported numbers suggest. The increase in troubled loans has much to do with the government’s efforts to rein in the growth of credit. In the first quarter, the volume of new credit declined 9 percent from the previous quarter. In March, the Chinese money supply grew at its slowest pace on record. This is why the government is now keen to boost bank lending.

The role of local government debt

One of China’s serious financial worries has been a spectacular rise in local government debt. It should be noted that local governments in China are not legally permitted to issue bonds or take on bank loans. However, they have been clever in exploiting loopholes in the law. Many have established off-balance-sheet financing vehicles that have issued bonds and borrowed from banks in order to fund infrastructure projects. When those projects have failed to generate sufficient returns to service the debts, governments have sold land to raise funds. The dramatic rise in the volume of local government debt has taken place in a rather opaque manner, without investors fully understanding the risks they face when purchasing local debt. Still, demand for such debt remains strong, probably because investors perceive an implicit obligation by the central government in Beijing to bail out troubled local governments or the banks that fund them.
Last month, the government said that it will allow local governments to issue bonds in the near future, with the hope that a secondary market for municipal debt will develop. Moreover, this market will be characterized by transparency with the release of prospectuses for investors. Beijing will place limits on the volume of debt that individual local governments can issue, and it will force the off-balance-sheet vehicles to be phased out. Initially this policy will apply to 10 large cities, including Beijing, Shanghai, Guangzhou, and Shenzhen. The government hopes that these actions will help local governments transition toward more responsible and transparent fund raising.

The impacts of housing and inflation

There are two important factors that will, in part, determine the degree to which the government will feel comfortable in loosening monetary policy. One is the state of the housing market,  and the other is the rate of inflation. 
First, it appears that China’s housing price bubble may be easing. The government reported that, in April, home prices rose in just 44 of 70 cities it surveys, compared with 56 cities in March. The April figure was the lowest in a year-and-a-half. Prices were flat in 18 cities. The slowing of home price increases reflects the impact of the government’s efforts to cool the housing market. Indeed, residential construction and sales of homes have abated, playing a role in the economic slowdown. In April, sales of homes declined 18 percent from March. The central bank recently urged banks to accelerate the origination of mortgages in order to provide a boost to the housing market. The  easing of prices should help to make home purchases more affordable to more households. In China’s big cities, prices barely moved in April. In Beijing, prices were up 0.1 percent from March; in Shanghai, prices were up 0.3 percent; in Hangzhou, prices actually fell 0.7 percent. If the housing bubble can be eased gradually, the government will have less incentive to quickly suppress credit growth.
On the other hand, there is substantial risk associated with the housing market. In the first five months of 2014, the value of home sales in China declined 10.2 percent from a year earlier. In addition, in the first five months of the year, new property construction was down 18.6 percent, and housing starts fell 21.6 percent from a year earlier. The drop in housing activity could hurt GDP growth figures for the second quarter. Moreover, this could portend falling house prices, which would have a negative impact on consumer wealth and on the health of financial institutions. A decline in prices would be especially worrisome given a recent trend where, contrary to government regulations, home buyers are being offered mortgages with no down payment. This is taking place in major cities such as Guangzhou, Shenzhen, and Beijing. As property prices peak, indicating a possible glut of new homes, lenders and builders are eager to originate mortgages in order to dispose of unoccupied properties. The risk, of course, is that this could hurt the financial health of banks if prices fall. This is similar to what happened in the United States prior to the Great Recession. The existence of no-down-payment mortgages means that unqualified buyers are likely being offered mortgages. With no equity in their homes, and with insufficient incomes to service their mortgages, defaults could rise precipitously if home prices start to fall.   Similar events precipitated the US financial crisis in 2007–08. The Chinese government actually requires down payments of 30 percent for first time home buyers, but evidently this rule is not being enforced.
The other important factor is inflation, which has tumbled. In April, consumer prices were up only 1.8 percent, the slowest rate of inflation in 18 months. Remember that a year ago, inflation was running quite high. There was concern that inflation inhibited the central bank from easing monetary policy lest it get worse. Now, with inflation under control, the central bank has more room to maneuver, especially in response to concern that the economy may be growing more slowly than the government’s target of 7.5 percent. Meanwhile, producer prices continue to fall, dropping 2.0 percent in April, the 26th consecutive month of decline. This reflects the considerable excess capacity in such industries as steel. Moreover, declining commodity prices, the result of weak Chinese demand, have contributed to falling producer prices and decelerating consumer prices. As to how far the central bank will go to ease policy, the issue now is whether the bank wants to strengthen growth at the risk of adding to excess credit market activity. Although the central bank needn’t worry now about inflation, it does have to balance concerns about growth with concerns about credit market risk. 

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1. “China’s focus on growth goals risks reform delay, World Bank says,” Bloomberg News, June 5, 2014,
2. “China’s Xi says fiscal reform urgent but needs planning:Xinhua,” Reuters, Friday, June 6, 2014, article/2014/06/06/us-china-economy-reforms-idUSKBN0EH20720140606.