Modern economies rely on complex financial systems to support growth and prosperity. At an earlier stage of development, China succeeded despite an immature financial system, as state-led investments in sectors such as infrastructure were high return. Today’s requirements are more complicated and risks are apparent. China’s financial reform goals include improving efficiency (return on investment) and reducing systemic risk while attempting to preserve state influence. China has made strides, but long-standing tasks remain unfinished even while new ones emerge and the cost of retiring old liabilities swells.

To gauge the state of financial system reform, we construct a quarterly incremental capital output ratio (QuICOR) as an acid test for efficiency; then we discuss the policies giving rise to this picture. The indicator tells us how much investment occurs relative to one unit of output growth: a lower ratio is better, with 3.5 being best practice internationally, according to International Monetary Fund (IMF) guidance. To supplement this analysis, we look at other indicators including total credit growth rates, the ratio of stock and bond financing to less direct channels, interbank lending rates, return of household savings, and foreign bond holdings.

Quarterly Assessment and Outlook

Our net assessment of China’s financial reforms stays at neutral. Beijing is pursuing a deleveraging campaign aimed at curbing systemic financial risk, and this has demonstrated some success at reducing key risks along with overall credit growth. Initially targeted at nonbank financial institutions (NBFIs, or “shadow banks”), it has since shifted focus to state-owned enterprises (SOEs) and local governments. Policymakers suggest deleveraging could take years. Our data show that the campaign has redirected credit away from the corporate sector and toward households. That has reduced corporate debt burdens, but at the cost of increasing household indebtedness, mostly mortgage loans. There is no evidence of more efficient use of credit: our primary indicator is not improving materially.

There are concerns that commitment to deleveraging will wane as growth slows, returning China to debt-fueled growth. The U.S.-China trade dispute increases this risk. However, we judge a complete reversal to be almost impossible given the size of risks and the fact that the shadow banking system has no real political constituency in Beijing. The deleveraging campaign is a major political priority to reduce systemic financial dangers, not just a short-term countercyclical measure. Despite this, some relaxation of regulation is expected over the coming months to prevent the appearance of a breakdown from feeding financial contagion and further tanking growth. This cuts to the core of China’s political-economic conundrum: Beijing needs to reduce systemic financial risks while somehow delivering enough growth to stabilize expectations. This year the growth in debt risk has been slowed, but no solution to channeling credit to more productive uses has been discovered.

Our primary indicator of financial system efficiency, the QuICOR, showed no significant improvement in 2Q2018. As a measure of China’s financial efficiency, the ratio is double the level of international best practice.

This Quarter’s Numbers

As deleveraging continued for a seventh quarter, headline credit growth declined to new lows (10.5% in 2Q2018 from 11% in 1Q2018) as measured by total societal financing (TSF), the state’s preferred credit measure (see Growth in Credit). This is the lowest single quarter of credit growth in our observation window since 2012 and is significantly below the 15.1% average growth rate from 2012 to 2017. Official bank loan growth was stable (12.7%, down from 12.9%). However, this was not driven by new credit growth, but by the recognition of previously off–balance sheet shadow loans migrating back to the formal loan book, in response to efforts to shrink China’s riskier shadow loan industry. These older loans do not create new deposits, which explains why loan growth has been much stronger than money supply growth of just over 8% year-on-year (yoy) during the quarter.

Policymakers are concerned about a sharp slowdown in economic growth. Industrial output growth is already slowing due to weaker credit growth, which will likely provoke Beijing to loosen credit policy. Despite this, we believe the overall policy priority remains deleveraging, given anxiety over systemic financial risks (see Policy Analysis below).

Interbank lending fueled growth in China’s riskier shadow banking sector in recent years and has been the target of tightening since 2016. Policymakers have had moderate success in shifting market expectations away from overconfidence in state support for interbank market liquidity at low rates, prompting an increased risk premium for shadow banks borrowing through these channels. A larger risk premium between banks and shadow banks is a healthy sign of markets at work, and that spread has been widening since the initiation of the deleveraging campaign. Our indicator of Interbank Lending Rates shows 2Q2018 average bank wholesale funding costs (7-day repo rates) at 2.80%, down slightly from 2.84% in 1Q2018, while the average for shadow banks is 3.03%, down from 3.04%. The spread is slightly higher while both levels are lower, reflecting the impact of monetary-easing measures to shift the yield curve lower.

Our primary indicator of financial system efficiency, the QuICOR, showed no significant improvement in 2Q2018, remaining at a ratio of almost 7 to 1. As a measure of China’s financial efficiency (see Overview), the ratio is double the level of international best practice. It is also deteriorating by China’s own historical levels, which were generally below 5 prior to 2015. Despite improvement from a peak of 7.21 in 3Q2016, the absolute level remains high, and the decline from the peak is modest.

Poor financial efficiency results in part from long-standing government guidance and interest rate controls, which are still major features of China’s system despite de jure liberalization. As our Return on Savings supplemental indicator suggests, the official interest rate on savings deposits (around 1.5%) is significantly lower than money market rates of around 4%. This price distortion encourages Chinese households to invest in risky alternative financial products, while low deposit rates provide comfortable profit margins for larger banks, giving them little incentive to be more customer friendly. Conversely, the need for smaller banks to compete for higher-cost funding encourages additional risk taking in lending practices.

Foreign participation in China’s financial markets remains low, despite consistently growing Foreign Portfolio Investments since 2017. Our indicator shows that foreign institutions hold 2.2% of domestic bonds in 2Q2018, up from 1.9% in 1Q2018. Total bonds held by overseas institutions in the Shanghai Clearing House and China Central Depository & Clearing Corporation accounted for 1.5 trillion RMB ($217 billion) of the total 71 trillion RMB ($10.2 trillion) market. Recently, foreign investors have been increasing holdings in Chinese government bonds in particular, as portfolio inflows hit a record high according to 2Q2018 data from China’s State Administration of Foreign Exchange.

Policymakers maintained focus on 'structural deleveraging,' a term Beijing uses to describe both cutting aggregate credit growth and redirecting credit to more efficient uses within the economy.

Policy Analysis

Policymakers maintained focus on “structural deleveraging,” a term Beijing uses to describe both cutting aggregate credit growth and redirecting credit to more efficient uses within the economy. Despite these priorities, monetary policy easing during the quarter drove market speculation that Beijing’s commitment to deleveraging was losing momentum. When the State Council announced on July 23 that it would use “proactive fiscal policies” and “ample liquidity” to stabilize the economy, some observers interpreted it as Beijing abandoning deleveraging objectives and resorting to stimulus again to invigorate the economy.

This expectation is misplaced. The Politburo of the Chinese Communist Party, the highest policy-making body in China, reiterated the importance of the “firm implementation of deleveraging” in a statement following its July 31 meeting, effectively eliminating any significant chance of a policy reversal. The State Council was also careful to note that fiscal support would be limited to “infrastructure projects that are already under construction” (although admittedly this type of official rhetoric has been a precursor to faster credit growth in the past).

Pushing debt reduction too aggressively risks creating defaults and triggering a crisis, so some “fine-tuning” of regulatory tightening measures is necessary. Signs of this were apparent during the review period. The People’s Bank of China (PBoC, China’s central bank) lent banks 502 billion RMB ($73 billion) via their medium-term lending facility in late July, primarily to improve liquidity in the corporate bond market. It also relaxed quarterly macroprudential assessment requirements for banks to facilitate the migration of off–balance sheet assets back to formal bank loans. On July 20, the PBoC issued additional guidelines for asset management product rules issued in April 2018, allowing financial institutions more flexibility in adjusting their balance sheets. The China Banking and Insurance Regulatory Commission announced new implementation rules on the same day, cutting the minimum purchase requirement for wealth management products (WMPs) to 10,000 from 50,000 RMB ($1,500 to $7,200), while allowing banks to continue to use a cost-based approach in some WMP valuations.

These measures should still only be regarded as relatively mild easing in the context of a wrenching adjustment resulting from the deleveraging campaign as a whole, given that credit growth has been cut almost in half since 2016. Regulatory tightening measures will probably not be completely abandoned after a diligent effort to create new infrastructure to control shadow banking activity. The campaign also continues to enjoy high-level political support, as evidenced from the Politburo’s July 31 statement.

Beijing also worries about “poor monetary transmission” – meaning that the system does not channel credit to the most promising firms (private ones) and sectors. Vice Premier Liu He, one of the leading figures associated with deleveraging, pointed out at an August 20 State Council meeting that small and medium-sized enterprises (SMEs) accounted for “50% of taxes, 60% of GDP, 70% of technological innovation, 80% of employment, and 90% of all businesses.” Liu wants them to see more than the roughly 30% share of credit they get today, while SOEs and local government-linked firms absorb the lion’s share. Banks continue to lend primarily on the basis of fixed assets as collateral and government guarantees, and those bias China against promising private companies.

In August, Chinese media reported that the PBoC would be restructured to have a presence in every province, as it did before Zhu Rongji implemented the current regional bank structure in 1998. The stated purpose of this change is to improve credit transmission to SMEs. However, ballooning local debt problems and desperation for local fiscal support (see Fiscal Affairs) provide troubling incentives for local authorities to influence banks for their own short-term political interests. Moreover, the lack of SME access to credit is a capital market design problem rather than a local regulatory issue. PBoC restructuring is unlikely to be the solution. Balancing the PBoC’s macroeconomic policy mandate against local government demands for financing remains a critical policy challenge.

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