China’s Subprime Risks

Of course, China’s leaders will also need to pursue major fiscal reforms, including improved revenue-sharing between central and local governments. In the longer term, the authorities must put in place stricter regulations to ensure that local-government infrastructure investments are sustainable and do not depend excessively on revenue from land sales.

In the interim, the burden of adjustment will fall largely on monetary policy, which will be particularly challenging given the structural tightness in liquidity in the more productive sectors. From 2007 to 2011, China’s money supply increased by 116%, whereas its foreign-exchange reserves grew by 180%. The excess was mopped up through statutory reserve requirements amounting to as much as 20% of bank deposits.

With the official banking system thus constrained, it allocated the remaining credit to large enterprises and those with sufficient collateral, resulting in an uneven distribution of loans across regions and sectors. As a result, large enterprises – mostly SOEs, which enjoy considerable financial subsidies and liquidity – accounted for 43% of total bank loans in 2011; small and medium-size enterprises (SMEs), which face financial repression, including higher borrowing costs and tight liquidity, accounted for only 27%.

This highlights two fundamental structural imperatives. First, large SOEs and local governments must be discouraged from over-investing, which undermines the rate of return. Second, more capital must be channeled toward SMEs and faster-growing regions, which are more likely to generate jobs and innovation.

In other words, interest-rate reforms must be pursued alongside capital-market reforms that boost access to credit by the more productive sectors. China cannot complete its transformation from an export-led economy to one driven by domestic consumption and services unless value creation through innovation exceeds value destruction from excess capacity.

In short, despite a strong national balance sheet and ample central-bank liquidity, China is confronting a localized subprime problem, owing partly to high reserve requirements. One promising move is the central bank’s recent release of CN¥1 trillion in liquidity through direct lending to the China Development Bank for the reconstruction of shanty towns, fulfilling the need for socially inclusive investment. Unlike the US Federal Reserve, it has not purchased subprime mortgages.

The key to success will be to manage the sequence of liquidity injections and interest-rate reforms so that the effort to address local subprime debts does not trigger asset-price deflation, while reducing financial repression that cuts off funding to more productive sectors and regions. If it manages to get these structural reforms right, China – and the rest of the world – will be able to avoid the consequences of a hard economic landing.

Andrew Sheng is Distinguished Fellow of the Fung Global Institute and a member of the UNEP Advisory Council on Sustainable Finance. Xiao Geng is Director of Research at the Fung Global Institute.

Copyright: Project Syndicate, 2014.