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 coordinate 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 downsizing 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 (IMF), 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 percent 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 maximizing 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 percent. In the six years to the end of 2016 China’s GDP expanded at an average rate of 8.1 percent in real terms. Growth this year will quite likely at least match last year’s 6.7 percent, so average annual growth of 6.3 percent in the next three years will put the economy over the line.
Third, China’s growth is becoming less dependent on credit-fueled 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 labor-intensive service sector. And the government seems likely to further boost pension payments and other types of transfers.
So a 6.3 percent 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.