Avoiding a Minsky Moment in China

Caixin: 实体经济去杠杆谨防出现明斯基时刻

I. Analysis of High-leverage Situation of China's Real Economy

The attributes of capital appreciation give original capital owners the ability to obtain income through investment. Investors can also use financial institutions to finance their funds, expand the size of disposable capital, and obtain more investment returns. This is the logic of economic pro-cyclicality. Due to the fragility of financial markets, the economic recession triggered by several financial crises has confirmed the systemic risks caused by the economic cycle fluctuations. Most market participants are not immune. Investment through debt expansion will virtually enlarge the transmission effect of market risk, and the size of the risk is proportional to the size of the leverage. The Chinese economy has experienced a period of high growth of more than 30 years, and there have also been strong cyclical economic fluctuations during the period. However, the policy of loosening monetary and fiscal easing has smoothed the crisis. The main features are as follows:

(I) The rapid increase in the total amount of money promotes the formation of high leverage

Before 2008, China’s monetary policy had been promoting economic growth with low inflation. In 1998, the Asian financial crisis adopted a method of stimulating domestic demand to prevent the economic downturn. In 2008, the US subprime mortgage crisis not only hit developed economies represented by the United States, Europe and Japan, but also affected the world. For monetary policy, with the emergence of the subprime mortgage crisis, many innovative financial instruments have emerged, and a large number of unconventional monetary policies such as quantitative easing, interest rate corridors, and inflation target values ​​have been adopted. During the crisis period in China, the new “four trillion” investment helped us hedge the impact of the subprime mortgage crisis, but it also historically pushed up the leverage level of the real economy. At the end of 2006 before the outbreak of the financial crisis, China’s broad money supply was 34.56 trillion yuan. By the end of 2017, the stock of M2 was 167.68 trillion yuan, a short span of 11 years, an increase of 4.85 times, with an average annual growth of 15%. As of the end of the first quarter of 2018, the broad money supply M2 of the renminbi was US$27.67 trillion, equivalent to the sum of the U.S. dollar and the euro. At the end of 2007, the renminbi’s money supply was only less than one-third the U.S. dollar and euro supply over the same period. One of them, the rapid growth rate during the decade is amazing. Especially after 2008, the non-financial sector’s debt growth rate exceeds the growth rate of M2, and a direct result of the flooding of the broad money supply is the rapid increase in leverage.

From a worldwide perspective, China’s generalized leverage rate is also high. According to the statistics of the World Bank for International Settlements (BIS), as of 2016, China's M2/GDP ratio is 202, which is far higher than the global average of 121. Judging from the generalized macro data, China's currency does have a relatively obvious super-discovery, and the generalized macro-level has a higher level of leverage. At the meso level, the non-financial sector includes the government, residents, and non-financial companies. The debt-to-GDP ratio of the three is an important measure of a country's leverage ratio. According to the statistics of the Bank for International Settlements, as of the third quarter of 2017, China's non-financial sector accounted for 256% of GDP, slightly higher than the international average of 244.7%, slightly lower than the 277.1% average level of developed economies. According to the statistics of the Bank for International Settlements, as of the third quarter of 2017, the debt ratio of the household sector in China accounted for 48% of GDP, the government sector accounted for 46.8%, and the corporate sector accounted for 162%, of which the proportion of the corporate sector accounted for highest.

All of that M2 has a claim on the PBoC FX reserves and Chinese FX reserves are less than 12 percent of M2. It is wrong to think of China as having any reserves. The yuan is effectively unbacked if there is a major crisis. Furthermore, the fact that CNYUSD tends to track with FX reserves, it's debateable as to whether they can spend any of it in defense of the currency. Which is why there are strict capital controls in place.

To put China's credit growth in perspective through the prism of M2 and FX reserves, back in May 2015 FX reserves covered 17.6 percent of M2. In order for the current FX reserves to cover 17.6 percent of M2, and assuming all of that adjustment was borne by the exchange rate (this is for illustrative purposes, not a forecast), USDCNY would rise to 9.85.

The effective allocation of capital as a market resource is affected by the distortion of the market, and it also causes the continuous accumulation of high leverage problems in the real economy. In particular, the existence of budget soft-constraints in the market is not only a “supply of gold”, but also leads to a drop in input-output ratio. The rapid growth of the real estate industry, the soft constraints of state-owned enterprises and local government financing budgets, and the reduction in the rate of capital input and output have led to the rapid growth of GDP, and the increasing debt burden of “zombie” companies, which in turn has inhibited the healthy growth of the economy.

The imperfection of China's credit market is reflected in the high proportion of indirect financing markets. The risk preferences of financial institutions converge, preference is given to mortgages, and the government increases the risk of credit extension; second, credit risk mitigation tools are missing, and traditional financial institutions have a severe risk pricing mechanism. As a result, state-owned enterprises, government financing, and real estate companies have high financing convenience. Even under the control of policies, due to soft budget constraints, they can obtain capital through high costs and form a crowding-out effect on SMEs. The state-owned enterprises have relatively high financing convenience. In the period of fund easing, the issue of high leverage is even more pronounced. The vitality of SMEs cannot be released, the input-output ratio is reduced, and economic growth will inevitably decline.

Deleveraging is having some positive effects, such as shadow banking hitting a brick wall:

As can be seen from the above chart, the proportion of non-financial sector in GDP in the third quarter of 2012-2017 is gradually increasing, from 194.6% in 2012 to 255.3% in 2016, an increase of 60.75 points in 4 years, an average annual growth of 15.17. Points. After 2016, the growth rate has slowed down. De-leverage has a significant effect. In the third quarter of 2017, the proportion of non-financial sector debt to GDP increased by only 1.5 percentage points compared to the end of 2016, which was basically the same as 2016, and the effect of macro-delegation was obvious.

Many sectors have seen constant or falling debt ratios, some suddenly such as steel. The auto industry has been stable, chemicals and mining more cyclical. The one sector with ever rising leverage: real estate.

From the above figure, we can see that the asset-liability ratio of the real estate industry and the building materials industry are basically the same between 2005 and 2008, but the trends after 2008 are obviously different, the real estate industry has been rising, and the building materials industry's financial resources have been down.

The conclusion is "deleveraging" and reform efforts are delivering positive results, but real estate and local government debt is a risk. The economy's ability to create credit is significantly retrained by new regulations, threatening a much faster than expected contraction in money supply.

Third, policy recommendations

Risks that may arise in the deleveraging process have already received regulatory attention. The first is the shift in regulatory attitudes. In the "China Monetary Policy Implementation Report for the First Quarter of 2018" promulgated by the Central Bank, the expression of monetary policy is "stable growth, structural adjustment, and risk prevention." Compared with the report for the fourth quarter of 2017, the restructuring has replaced deleveraging. It shows that the regulator's attitude towards leverage adjustment has quietly changed. The current trend of increasing macro leverage has been significantly curbed, and at the same time frequent violations, and the central bank’s policy statement at this time just shows that the attitude of supervision has changed from de-leverage to stable leverage, at least at the macro level. Followed by the structure of policy operations. The tone of the central bank’s monetary policy this year is still stable and neutral, and maintaining a reasonable supply of liquidity will not flood the country, nor will it further tighten liquidity. There are also significant changes in the structure of the policy. For example, this year, the central bank created PSL deposits, set up temporary reserve arrangements, and adjusted the supply of funds through convenient financing tools such as MLF, SLF and repurchase transactions, and at the same time further extended liquidity for the market by expanding the range of MLF pledged bonds. However, the consistency of risk preferences of financial institutions will lead to a vicious circle of credit markets, and the liquidity of financial markets cannot be effectively transmitted to the real economy.

After the US subprime mortgage crisis, the policies of quantitative easing (even zero interest rate policy) and tax cuts were used to feed the real economy. As the market mechanism was relatively complete, a large number of low-interest-bearing currencies entered the emerging markets and gained capital gains before returning to the United States. Even if we enter the rate hike cycle, the real interest rate remains at a low level. Under the premise that China’s monetary policy is currently neutral, the central bank’s currency is increasingly diversified, but considering the hedging effect of stabilizing the exchange rate mechanism, it is difficult to reasonably control the growth rate of the base currency. At the same time, shadow banks, which account for a relatively large proportion of the total social financing, have lost the function of money [credit] creation in a relatively short period of time, and the contraction of the total money supply may exceed expectations. In particular, the “corporate debt repayment crisis” brought about by liquidity risks may further aggravate the market environment created by credit. Under the dual tightening effect of weakening real economy demand and superposition of financial institutions to reduce supply, debt risk can easily lead to systemic risks. If the actual financing rate of the real economy does not fall, the debt problem will not only be contained, but will also lead to greater risks.

From the effect of deleveraging, we can see that in the process of deleveraging in the real economy, after two years of adjustment in the traditional “two high and one surplus” [high pollution, high energy consumption and overcapacity industries], the “survival of the fittest” has achieved significant results, but the implicit debt of local governments and the leverage of the real estate industry have risen instead of declining. Therefore, the main contradiction should be grasped. For industries such as real estate, "two highs and one surplus", and local governments and other soft budget constraints, clearly put forward the goal of reducing leverage, and take targeted measures, such as supporting fiscal and taxation policies, etc. Related areas control debt The risk has risen further and is isolated from other industries to avoid the risk of infection and to prevent Minsky moments of market resonance effects.

The article is by the General Manager and Deputy Researcher of the Asset Management Department of the Postal Savings Bank.