As analysts downgrade their expectations of what will come out of the plenary session of the 18th Party Congress next month – it seems Beijing won’t announce detailed reforms on opening up state-owned enterprises nor reform of the hukou [household-registration] system – Xiang’s unusually candid remarks on the political hurdles to reform are a sobering reminder of the complexity of the challenge. In an otherwise relatively upbeat assessment, Euromoney spoke to the economist about China’s short- to medium-term health.
Global markets are poised on a knife-edge, in part thanks to fears over China’s rising debt burden. There is a lack of consensus on the scale of the problem. What’s your take?
Government debt consists of six parts. The first is bank lending, which, at end of second quarter, reached Rmb9.74 trillion ($1.6 trillion). The second is bonds issued by financial platforms established by local governments, which is around Rmb3 trillion. The third part is trust products issued by financial institutions on behalf of local governments, and that’s around Rmb3 trillion. The fourth part is intra-government borrowing, such as a municipal borrowing from the provincial authority – and that’s about Rmb1 trillion. The fifth part is the local government raising money through the shadow banking system.
The national audit committee is now conducting an audit to determine the size of this. The four parts put together is roughly Rmb16 trillion, so the question is how big is the shadow banking debt? This could be around Rmb3 trillion to Rmb4 trillion in my view, which means local government debt would equate to Rmb19 trillion to Rmb20 trillion. Meanwhile, central government debt is Rmb15 trillion. This means China has a total debt burden of Rmb35 trillion, or 67% of GDP. Why do people worry about it? Most of it this debt is transparent, though there are real questions about where some bank loans are going.
What are the origins of China’s debt troubles?
After the financial turmoil in 2008, local governments used this opportunity to borrow aggressively. They did so because they have a very strong political incentive to do so: to meet GDP targets. Sometimes local government officials forced local state bankers to lend them money for their pet projects. What’s more, big banks also have an incentive to lend to their pet projects. That’s a problem.
Is a local government debt crisis on the cards?
We should have an objective judgment of stimulus projects. In my view, they have mostly been good. A small number of these projects won’t generate sufficient cash revenues to pay off debt. We must learn lessons from this. That’s why China is pushing through financial reform. The most important issue is to change the incentive structure for lending. All these big banks are public companies, so there is market pressure on their nonperforming loans and balance sheet, more generally. Investors will express their concerns about issues surrounding the decision-making process behind credit creation.
At present, the central government still holds a large stake in these banks, but they have expressed an intention to reduce their share. This should happen at a quicker pace. Of course we will not see an outright dismantling of state involvement or full privatization. The government will still ultimately hold a controlling stake of these lenders, but more market discipline will help [boost transparency and discipline].
What lessons can we learn from the mini liquidity crisis in June?
It’s important to remember that all financial institutions in China rely on cheap money from central bank to lend to companies or buy financial products for high return. It’s a free lunch. When the People's Bank of China decided to curtail this trend, it sent a clear signal to FIs: you must have a good liquidity base in the future because you cannot rely on the central bank in the future. It’s a good to inflict some penalties to get your institutions in order.
Secondly, the central bank must have some sort of policy target. The PBoC has multiple objectives: to control inflation, promote growth and maintain financial stability. The question is how to implement this mandate. The PBoC has M2 growth rates in mind at around 13% year-on-year. But in the recent two quarters M2 has grown at 16%. That’s why in June they tried to control this monetary aggregate.
The tug-of-war between China bulls and bears has assumed a more partisan tone in recent years. There are many hedge fund managers and analysts that have staked their careers betting that China’s financial system will blow up eventually. Why do you think China-as-the-new-Lehman pitch is so fashionable?
I wonder about this all the time. I think there are two fundamental reasons. Some foreign analysts don’t understand China’s growth model very well. We are in a very different stage of growth and development than other countries. And there are some foreign analysts who simply can’t believe China’s growth story. They think it’s too good. They don’t understand how China can grow so fast for so long. In addition, a key reason to misjudge China is the fact many outside observers don’t take into account the political advantage of the regime. China has a disadvantage when it comes to transparency, but [the ruling party] has an advantage with respect to stability and can implement decisions with speed.
How should we judge the success of China’s reform agenda?
The success of all these economic changes rests partly on a successful change in political system. For example, to reform SOEs you need to tackle their privilege. They have become a vested interest group with very powerful political support. How to change that framework is the question. Take another example: in order to contain pollution, you must change the incentive structure of local leaders and ensure they don’t pursue GDP targets and instead pursue social objectives. Fortunately the central government did not set growth targets this year and won’t do so in the future.
When do you think the capital account will be convertible, and will the renminbi weaken or strengthen when this takes place?
I think the capital account will be convertible in three to five years. When this happens, I think the renminbi would strengthen, as China will remain one of the most promising investment destinations, so demand will be strong.