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 the state of China’s financial reform holds at neutral in this Dashboard review period. Authorities are making progress on curtailing risk – a stated 2013 Third Plenum reform goal – through a successful deleveraging campaign. Credit growth is falling sharply, driving a slowdown in the economy that is not yet revealed in headline growth data but is apparent in a series of other indicators throughout our Dashboard for 1Q2018. Corporate defaults are increasing – a signal that financial markets are doing a better job of pricing risk. Beijing needs a stronger role for the market in allocating capital if it hopes to develop an efficient and sustainable financial sector. But our primary indicator shows that nearly seven units of capital are still needed to drive one unit of additional output in the economy – an alarm bell warning that credit allocation remains far from efficient.

Beijing’s principal financial policy challenge is to lock in deleveraging progress while easing monetary policy to support the real economy. Simultaneously making credit more available and curtailing financial risk is a tall order even for advanced economies with credible and independent financial regulators. Can deleveraging remain effective in a context of easier credit conditions that have fueled so much speculative finance in the past? Or will Beijing once again tolerate increasing financial risk to stabilize the economy? The coming quarters are shaping up to be a critical test of the Chinese government’s willingness to enforce financial discipline and achieve stated goals of improving financial efficiency and reducing risk. Whether this time truly is different will be revealed in our next quarterly sets of indicators.

While China repeatedly pledges financial openness, foreign participation in its financial markets remains low.

This Quarter’s Numbers

Our primary indicator shows that the financial system remains an inefficient allocator of capital. The indicator is an incremental capital-output ratio (ICOR), which gauges how much investment capital is required to generate one unit of economic output growth. It remains in dangerous territory in this review period: the ratio is at 6.95, basically unchanged from 6.96 in our last review period. This means that nearly 7 units of capital are needed to drive 1 additional unit of GDP output. The primary indicator gradually declined from a peak of 7.21 in 3Q2016, but improvement is not yet sufficient to alleviate systemic risks from credit misallocation. This is not a healthy or realistic footing on which to build toward a sustainable economy.

Our Return on Savings supplemental indicator also reflects continued financial repression, a situation in which the government deliberately holds down interest rates for borrowers at the expense of lenders. The indicator shows that the yield offered on private deposits in money market funds (as measured by Yu’e Bao fund returns) increased 16 basis points (bps) from last quarter to 4.12%, while there was no change in the official household savings deposit rate at 1.5%. This gap between the two is a proxy for financial repression because most deposits made by Chinese households are limited to the low, “plain vanilla” bank rates, while the higher rates offered by Yu’e Bao reflect what return those deposits should be receiving were the government not keeping the cost of capital to borrowers artificially low by controlling interest rates. To its credit, the People’s Bank of China (PBoC), China’s central bank, is making some progress on unifying deposit and money market rates, with the latter trending lower and formal deposit rates moving up. This should reduce financial repression over time, but progress so far is insufficient to show up clearly in our indicators.

On the positive side, data show that policy efforts to deleverage the financial sector are slowing credit growth, as in our last Dashboard edition: banks and shadow banks are lending less, the cost of capital is going up (modestly), and thus demand for new credit is slowing. These are the classic results of tightening. Growth in total social financing (TSF), China’s idiosyncratic financing measure, slowed to 10.5% year-on-year (yoy) from 12.0% in 4Q2017. This is the lowest quarterly reading in our observation window since 2012. Bank assets grew by only 7.3% yoy, the slowest pace in recent history and half the rate seen at end-2016. This shows that financial leverage is decreasing – a clear success for financial regulators. The government also continued forcing banks to move off–balance sheet loans back onto balance sheets, meaning that truly new bank lending was lower than the reported 12.9% growth shown in our supplemental indicator Growth in Credit.

Other data show regulators effectively squeezing risky financial actors in another deleveraging success. Overall shadow bank assets narrowed for the first time on record in 1Q2018 according to official data from the PBoC. Whether this situation will last is uncertain: our Interbank Lending Rates indicator also shows that the spread in funding costs between nonbank financial institutions (NBFIs, or shadow banks) and normal banks is narrowing, with the lending rate in the interbank market for shadow banks falling to 3.04% in 1Q2018 from 3.30% in 4Q2017. Normal bank funding costs also fell to 2.84% from 2.88%. Shadow banks should be paying higher returns than normal banks for financing given their higher risk profiles, so this narrowing spread between the two raises uncertainty about whether shadow bank assets will continue to contract in future quarters.

Finally, while China repeatedly pledges financial openness, foreign participation in its financial markets remains low (see Foreign-Held Bonds). Our indicators show that foreign investors only hold 1.9% of domestic bonds, up from 1.7% in 4Q2017, although 1.9% is already the highest quarterly reading since 2014. Total bonds held by overseas investors in the Shanghai Clearing House and China Central Depository & Clearing Corporation increased modestly to RMB 1.3 trillion in 1Q2018 from RMB 1.1 trillion in 4Q2017. This is a drop in the bucket of the RMB 70 trillion bond market.

Policy Analysis

Beijing is attempting to balance between stronger financial regulations to lock in progress on deleveraging and easier monetary policy to support a slowing economy. Achieving both simultaneously may not be possible. If financial regulations prove inadequate, Beijing will be forced to choose whether or not to accept a resurgence of financial risk to either boost growth or keep monetary policy tight and accept slower growth to prevent another round of credit-fueled speculative financial behavior.

Beijing showed that it is willing to test the waters of looser monetary policy. In April, the PBoC announced a 100 bps cut to qualified banks’ reserve requirement ratios (RRR), effective April 25, which provided approximately RMB 400 billion to the banking system. A month later in May, macroeconomic data offered new insight into slowing growth: fixed asset investment data recorded the lowest monthly growth (6.1%) since 1999, retail consumer products sales reported the lowest monthly growth (8.5%) since 2003, and industrial output growth also weakened. In response, on June 20 an executive meeting of the State Council called for another RRR cut to support small- and medium-sized enterprises. On June 23, the PBoC then made the cut official for banks meeting “certain criteria” (effective July 5). The bar for meeting those criteria was not particularly high; thus, the cut applied to most banks. Estimates are that the cut released RMB 700 billion in additional liquidity.

Beijing’s choice to ease monetary policy is not an easy one given global financial market dynamics: the U.S. Federal Reserve raised its benchmark interest rate by 25 bps on June 14 and is expected to continue moving its benchmark rate higher throughout the year. Rising interest rates in the United States pressure the PBoC to raise interest rates and narrow the yield spread between RMB and USD assets – which would stabilize the RMB exchange rate and limit capital outflows. As Beijing cuts rates instead, the opposite will be true: lower rates in China will encourage more capital to flow out of RMB assets and thus weaken the currency. Just at the drafting of this Dashboard edition, Beijing’s challenges in managing these trade-offs were apparent, as the RMB fell in value by more than 6% against the U.S. dollar from June 13 to July 23. Beijing also imposed tighter financial regulations during the review period, aligned with deleveraging aspirations. The biggest policy development was the imposition of the new restrictions on the country’s RMB 100 trillion wealth management product (WMP) market, which were discussed at length in our Spring 2018 Dashboard edition. The regulations came into effect on April 27 and imposed significant new restrictions on the WMP market, including banning issuers from guaranteeing principal repayment. The regulation extended the compliance window for WMP issuers to December 2020, from June 2019 in an earlier draft. Still, this means that financial institutions that aggressively expanded their balance sheets by selling problematic WMPs will have to significantly curtail those products and wind down risk over the next two years.

Recognizing the likely accelerating effect that monetary easing will have on capital outflows, Beijing is also attempting to attract more inflows as a counterbalance. This is positive and aligned with longer-term reform and liberalization goals. On June 12, the State Administration of Foreign Exchange (SAFE) reduced lockup periods and profit remittance restrictions for investors participating in the Qualified Foreign Institutional Investor (QFII) and RMB-Denominated Qualified Foreign Institutional Investor (R-QFII) schemes. QFII and RQFII offer foreign investors access to China’s securities markets under set quota allotments; loosening the restrictions should be supportive of greater inflows. Still, these carefully managed programs fall well short of full financial openness. Our indicators showing the low rate of foreign financial participation reveal how far Beijing has to go.

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