Migrant worker in Beijing on 7 June 2020
Short analysis
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Stimulus package reveals China’s financial constraints

The stimulus plan Premier Li Keqiang announced at the National People’s Congress (NPC) in May steered clear of a new credit deluge. In this respect, it is very different from the rescue plan that flowed forth in response to the 2008 global financial crisis. A look at the state of the financial sector suggests why, says MERICS Visiting Academic Fellow Michiel Haasbroek in the second part of his analytical series on the impact of the Coronavirus crisis on China’s financial sector. You can find part 1 here.

China has been piling up financial challenges that had been only partially resolved at the start of 2020.  Hence, the current stimulus plan arrives in a different context and will have fewer beneficial external effects. Compared to 2008, returns on investment have fallen, fiscal flexibility has shrunk, and reserves as a share of GDP have dropped significantly. On the positive side, China’s regulatory framework is more robust on both macro- and micro-prudential oversight. But will regulators be able to exercise their authority when the economy falters?

During the delayed NPC, which is normally annually held in March, some clarity emerged on the commitment to, nature of, and modalities of the post-Covid economic stimulus. While Chinese reports indicate that it is focused on long term “high quality development”, it is clear that the plan contains as many constraints as opportunities. Absent a growth target for the year, a detailed look at what is under the hood may offer a glimpse at the likely speed of China’s recovery.

Financing small and medium enterprises is vital

Perhaps most striking is the absence of outright monetary easing. Rather than making interest rate cuts that would dent the profitability of banks, the central bank is focusing on the provision of liquidity. This is understandable, given the concessions that have to be made by banks to avoid a deluge of non-performing loans. Cuts in the reserve requirement ratio (RRR) – the part of a bank’s deposits that is to be held with the central bank for monetary sterilization – provide a more targeted approach. Reductions in RRR, the portion of a bank’s reserves that must be held by the central bank, free up cash. The objective is to give banks greater flexibility to channel funds to small and medium enterprises (SMEs). One of the most pressing issues is around unemployment, so financing SMEs is of central importance.  

However, reducing the lending bias and making more credit available to private firms in an ecosystem that privileges state-owned enterprises is a long-standing objective which has only been marginally successful. Many SMEs have relied on irregular finance, such as shadow banking and peer-to-peer (P2P) lending. These avenues were choked off, before the coronavirus crisis unfolded, in a zealous but poorly coordinated push by regulators. It is possible that a large part of the newly available liquidity will go into the refinancing of existing debt, as companies struggle for survival. If so, it will contribute little to economic growth. Recent discussion on allowing street vendors back in major cities illustrates the diversity and informality of parts of the SME sector, and the difficulty of reviving the SME sector as a whole.

Local governments are lured to spend on “new infrastructure”

The other significant move is that local governments are once again being enticed to spend. This time, however, the allocations for new bond issuances include a control mechanism, in contrast to the frenzied implementation of the 2008 stimulus. It remains questionable how these measures will address rising unemployment and what sort of jobs they will create. This time around, local authorities will have access to cheaper finance (as bond rates are lower than lending rates) and can meet the banks’ demands owing to their zero percent risk weight (thus offering capital-efficient returns). Local authorities have been tasked with focusing on improving China’s “new infrastructure”. If they fulfill the vision and technologically advanced projects prevail, it is hard to see how bond issuance will contribute to providing employment for migrant workers directly. A more likely scenario is that migrant workers will “benefit” from urbanization in obtaining low-skill employment such as motorcycle delivery services.

Fiscal spending and the increased fiscal deficit target show that, this time, the central government will shoulder responsibility by taking on part of the financing burden. It also means that central government debt will increase, right at a time when China’s bond markets can bask in substantial external demand. As such, it helps to create investible assets, thereby supporting the business model of insurers.

Bond market plays crucial role in making funds available

The Chinese bond market has grown significantly over recent years. It offers lower funding costs compared to bank lending and has the ancillary benefit that it relies more on market forces, as bonds are traded instruments (even though the lion’s share is held by banks). However, there are reasons to view them with caution. First of all, at the end of 2019, there were significant concerns that there would be a deluge of bond defaults, as financing conditions were tight and maturities would expire in 2020. We have also seen that the rating of bonds was sometimes problematic; they were generally receiving high ratings in international comparison, and signals of financial difficulty for borrowers were being factored in too close to default. On this basis, we can expect that funds will be made available to roll over existing debt, or the financial equivalent of kicking the can down the road.

A note of caution on potential cracks in the financial fortress should be applied to the external position too. China has a large net debt position, meaning it owes less to foreign entities than it is owed. Yet a large part of that external debt is linked to Belt and Road (BRI) projects that have faced substantial calls for debt relief. As China is not a Paris Club signatory, a group of international lenders in development finance, it is not governed by the club’s agreed terms and principles for the development debt relief and restructuring. Its loan documentation is closely guarded, it is only possible to speculate how such requests from BRI- partner countries will be handled. It seems likely that some form of debt relief will need to be negotiated, and doing so would hurt China’s net debt position. At the same time, China’s external debt has increased to an amount much closer to its stock of foreign exchange reserves.

Conclusion: Stimulus will put reform and deleveraging on the backburner

Fundamentally, we see a return to spending on infrastructure, and it is unlikely that this can be done while controlling overall debt levels. We can expect that greater support will need to be given to privately owned enterprises (POEs) and SMEs, which may well mean that some of the shadow banking curbs will need to be relaxed. This is now the crucial balancing act at the heart of China’s economy.

Overall, the stimulus will put reform and deleveraging on the backburner, as it requires a careful navigation of financial risk. It is unlikely that stimulus funds will support long-term objectives around developing China’s Western regions, enhancing domestic innovation, or addressing the future labor scarcity resulting from decades of strict birth control. Nevertheless, the emphasis on “new infrastructure” implies that there will be more attention to enhancing urban service provision.

The political focus on improving the people’s quality of life will continue. However, more is needed if the government is to stave off mass unemployment. Any success in tackling the employment problem is likely to come at the expense of wider structural reform. The 2008 stimulus still casts a long, dark shadow over China as its after-effects and their ramifications still place limits on current stimuli. For that reason, the authorities gave themselves more time to think this program through than happened in 2008, so as to avoid the creation of future constraints. However, the package comes at the expense of ambitious economic development targets.

This was part two of a three part series. Continue reading in part three.

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