The People’s Bank of China (PBoC) has cut interest rates for the third time in six months in order to lighten the debt burdens of companies and local governments. But the central bank’s monetary easing – accompanied by complementary fiscal and administrative adjustments – has done little to increase demand for new loans. Instead, it has triggered a sharp rise in China’s stock markets. The question now is whether that could turn out to be a very good thing.
There is little doubt that China’s economy is shifting gears very quickly. Official statistics show a slowdown in real growth in the old manufacturing and construction-based economy, reflected in declining corporate profits, rising defaults, and an increase in non-performing loans in poorer-performing cities and regions.
Meanwhile, the government’s policies to tackle corruption, overcapacity, excess local-government debt, and pollution have put downward pressure on investment, consumption, and the government’s capacity to deliver its promised growth rate.
With harder budget constraints imposed by the central government, local officials and state-owned enterprises (SOEs) have curbed their spending on investment, and are now being overly cautious. In the short run, this restructuring could lead to localized balance-sheet recessions, despite the authorities’ efforts to create a more accommodating macroeconomic environment.
The private sector, by contrast, is picking up steam, with recent administrative reforms having contributed to a 54 percent rise in business registrations since March 2014. Increased innovation and the rise of the services sector have helped China move beyond its role as the world’s factory to develop its own version of the Internet of Things, driven by platform companies like Alibaba and Tencent.
Some 14.3 million new stock-market trading accounts were opened in China last year. And the PBoC’s interest-rate cuts, together with reductions in banks’ mandatory reserve ratios, have fueled a rise in the Shanghai, Shenzhen, and ChiNext indices — by 95 percent, 198 percent, and 383 percent, respectively, since January 2013. Chinese stock-market capitalization grew from 44 percent of GDP at the end 2012 to 94 percent of GDP earlier this month.
This has important potential implications – both positive and negative.
On the positive side, the revival of China’s stock market in a low-interest-rate environment represents an important shift in asset allocation away from real estate and deposits. Roughly 50 percent of Chinese savings – amounting to as much as half of GDP – lie in real estate alone, with 20 percent in deposits, 11 percent in stocks, and 12 percent in bonds.
To compare, in the United States, real estate, insurance, and pensions each account for about 20 percent of total savings, with 7.4 percent in deposits, 21 percent in stocks, and 33 percent in bonds.
Rising stock-market capitalization also helps to reduce the real economy’s exposure to bank financing. The US is much more “financialized” than China, with stocks and bonds amounting to 133 percent and 205 percent of GDP, respectively, at the end of 2013. Those ratios were only 35 percent and 43 percent, respectively, in China.
Meanwhile, bank assets amounted to 215 percent of GDP – more than double America’s 95 percent.
Finally, China’s surging stock prices increased net wealth by 37 trillion yuan (US$6 trillion), equivalent to 57 percent of the nation’s GDP, in just 18 months.
If stock prices can be sustained, the implications for consumption, liquidity, and leverage will be profound. Smart households and entrepreneurs could take profits and reduce their debts. Similarly, both private enterprises and SOEs could use market buoyancy to raise equity to fund new investments.
But the rapid run-up in equity prices also carries considerable risks – namely, the possibility that the financial sector will misuse the newfound liquidity to finance more speculative investment in asset bubbles, while supporting old industries with excess capacity.
That is what happened in 2008-2009, when a run-up of the Shanghai index (which reached 6,092 in October 2007), together with the government’s 4 trillion yuan stimulus package, sustained overcapacity in traditional industries. Most of the credit went to real estate and local infrastructure projects, effectively reinforcing the most problematic trends in China’s economy.
This time, one hopes, will be different. But even if Chinese retail investors begin to channel their money toward innovative ventures, identifying the companies and industries most likely to succeed will be difficult.
In the US, the collapse of the tech bubble in 2000 entailed a US$4 trillion loss in market capitalization. But the US managed to avoid a systemic crisis. If China’s animal spirits are allowed to operate through market mechanisms, distinguishing real value from aspirational prices, China, too, can stay the course toward the new economy, despite the failures and consolidation that will inevitably occur.
As China’s animal spirits are channeled, they will increasingly test the authorities’ resolve to resist price intervention, instead allowing market forces to propel the business cycle. This will not be easy, given that the PBoC has plenty of additional room for monetary easing.
Indeed, at the end of last year, China still had 22.7 trillion yuan of statutory reserves, amounting to 36 percent of GDP, that had long been used to “sterilize” its large foreign-exchange holdings. Such “locked liquidity” can be returned to the market in the form of new bank credit or new equity.
That is why the real test of China’s administrative reforms is whether, through improved bankruptcy mechanisms and regulations that block fraud and market manipulation, they allow – and even facilitate – the effective functioning of market forces. With animal spirits – not the authorities – guiding it, China can build the high-value-added, high-tech economy it needs to compete in the future.
Copyright: Project Syndicate
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