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How China can escape the debt trap

Chinese President Xi Jinping (L) talks to Chinese Premier Li Keqiang (R) at the closing the 3rd Session of the 12th National People's Congress on March 15. Photo: AFP/Getty Images.

Much of the commentary on China today assumes that the country’s economy is trapped in a depressing trade-off: Either it piles on more debt and exposes itself to financial crisis, or it curtails credit and risks the kind of slowdown that could provoke a social backlash. But this narrative overlooks the potential for structural reforms to provide China with an escape route out of its debt problems.

Gauging China’s first-quarter economic momentum is always tricky because of the weeklong Lunar New Year holidays, during which many workplaces shut down. But evidence suggests that the economy has slowed in early 2015. This is as we would expect from the credit-tightening implemented since the spike in interbank interest rates in June 2013. New financing contracted each month, year on year, between July 2013 and December 2014. Policy easing and efforts to bolster the credit to certain favored sectors have failed to offset the regulatory squeeze on shadow-banking activity.

Given the historical relationship between credit and growth, this suggests that the first quarter of 2015 should be even weaker than a year ago before a modest pick-up later this year. So far, backward-looking indicators in 2015 have generally been below expectations, while forward-looking indicators have been more encouraging. Fitch expects GDP growth of 6.8% for 2015 against the government’s target of “around 7%.”

Still, Beijing has continued to run a broadly tighter policy in an effort to deal with the hangover from all the credit unleashed in 2009 to offset the global financial crisis. Credit expanded, in real terms, by more than 30% in 2009 and 20% in 2010. The overall debt-to-GDP ratio for the whole economy hovered around 125% between 2005 and 2009. Fitch estimates that it reached 242% by the end of 2014 and is still rising despite the recent deceleration.

Since Fitch first took a negative action on China’s rating in 2011, we have expected that Beijing would assume some of the broader economy’s debt burden. Its recent view—that a wider deficit is needed to help the economy through the deleveraging process—points in this direction. The central government’s approval of one trillion yuan ($160 billion) in local-government debt issuance, to refinance debt due in 2015, may be another step in this direction.

In spite of all this, the parts of the economy that are less credit sensitive and more consumption-oriented have continued to do tolerably well. This is no surprise, as households are net savers. Seasonally adjusted retail sales rose by an annualized rate of 11.2% in February, month-on-month, compared to an average of 10.9% over 2014. The nonmanufacturing purchasing managers’ index was an expansionary 53.9 in February, up from 53.7 in January.

This resilience gives us a clue as to how China might escape the debt trap. Through structural reforms, Beijing could open up space for more consumption-oriented and less credit-intensive activity, which could in turn keep the economy growing at close to full employment. This assertion may seem a bit too convenient. However, there is little sign so far of a shake-out in the labor market, even as growth has slowed toward 7% from an average of 10.8% during the 2002-10 period.

The main areas to watch this year are deposit-rate liberalization, fiscal reform and reform of state-owned enterprises.

Deposit-rate liberalization is probably the single most powerful available engine for rebalancing and reform. It would almost certainly lead to higher deposit rates, currently capped at 3.25%—low for an economy experiencing nominal growth of about 8%. A higher cost of capital would put more money in the bank accounts of households, raise household wealth, stimulate consumption and discourage less-viable investments. (This is why the central bank has widened the maximum permitted variation over the policy deposit rate even as it has cut rates since November.) Beijing has set a 2015 target for the introduction of a deposit-insurance scheme, seen as a prerequisite for deposit-rate liberalization.

Fiscal reform—to rebalance the resources of the central government against the local ones—will be necessary if authorities are serious about reforming the hukou system of household registration, which currently ties citizens to their hometown and denies migrants from the countryside from accessing urban social services. Strengthening migrants’ access effectively raises household wealth. It would also entail costs for local governments, but those areas receiving migrants—typically the wealthy eastern coastal provinces—are generally those with the broadest fiscal shoulders.

State-owned-enterprise reform is a vast and detailed area in its own right. The imbalance of the economy toward investment and away from consumption is matched on the income side by the skew toward corporate profits at the expense of household income. Much of the government’s supply-side reform agenda can be understood as an attempt to address this by reducing corporate access to uneconomically cheap resources—natural resources, land, labor or capital. If implemented, China stands to unlock productivity gains that would directly support growth prospects. But it will require tackling powerful vested interests.

We should not be too sanguine about the risks. A sharper-than-expected slowdown in construction could lead to higher unemployment and undermine the consumption side of the adjustment story. China’s opaque financial system could also throw up unpleasant surprises. But the longer China delays the task of reform and the longer it remains on the path of rising indebtedness, the greater the risks of an inevitable adjustment.

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