Sara Hsu
China’s banking system is under pressure as regulators attempt to reduce risks stemming from shadow banking and excessive corporate leveraging. The US–China trade war is adding to this pressure by threatening to further slow growth. The Chinese government is in a bind since its go-to methods to stimulate the economy are among the main causes of this current headache. China’s central bank has stressed that it will stay on a course of prudent and neutral monetary policy, while ensuring that there is sufficient liquidity in the financial system. Keeping financial risks at bay is a major aim. In other words, it is unlikely that the central bank will inject a large amount of funds into the economy, but rather just enough to maintain policy targets.
Still, some monetary stimulus has already been implemented, and fiscal stimulus promises to generate some new demand. But over time, China’s regulators may have to choose between maintaining financial stability and spurring growth.
The current situation is particularly bad for the Chinese finance industry. China’s banking system is under strain due to high loan-to-deposit ratios, lagging new deposits and the spectre of non-performing loans. New restrictions on the use of shadow wealth management products have reduced bank income. Pushing these products back on to bank balance sheets has constrained their lending capabilities. In response, banks have unloaded a number of non-performing loans to asset management companies. This process is likely to continue.
In the first half of 2018, total disposal of non-performing loans officially reached 800 billion RMB (US$116 billion), around 167 billion RMB (US$24 billion) higher than in the first half of 2017 due to tighter restrictions on recognising bad loans and lower levels of liquidity in the banking sector. Although the ratio of non-performing loans has remained under two per cent, some analysts estimate the actual ratio to be far greater at up to 80 per cent of all loans. But this discrepancy should decline due to increased recognition of bad loans on banks’ balance sheets.
The government is in a very difficult position regarding the banking sector. It is caught between the need to constrain lending to stave off further bad loans and the need to loosen lending to combat the slowing economy.
The Chinese government has eased capital requirements to increase liquidity in the financial sector due to the US–China trade war. Banks’ reserve requirements have been cut three times this year to improve liquidity. The central bank has also used medium-term loan facilities to provide funds to the financial sector.
In addition to the increased liquidity, the Chinese government has also begun fiscal stimulus to bolster economic growth. China’s central government has asked local governments to expand spending on infrastructure projects and agriculture. This request is expected to result in a surge of bank loans as local governments seek to fulfil this directive in the face of constrained revenue. The banking sector has also been asked to provide loans to small export-oriented firms caught in the crosshairs of the trade war.
All of these items may result in a greater number of bad loans in the medium run, as happened due to the use of fiscal stimulus just after the global financial crisis hit China.
Because of the banking sector’s close ties to the government, financial stability can and will be tightly controlled. Banks will likely be forced to lend to entities that would otherwise not receive extensive funding, such as local governments. Funds will be granted where the government desires at the expense of some of the riskier loans. We saw this happen time and again in the wake of the global financial crisis, as local governments followed orders to build infrastructure by creating bridges to nowhere and ghost cities.
This time around, waste may be less blatant but is unlikely to be eliminated. In the end, the central government will probably step in once again to convert the non-performing loans to municipal bonds or sweep them off banks’ balance sheets to asset management companies.
The trade war has exacerbated China’s dilemma of stimulating the economy to avoid slowing growth and tightening the economy to reduce financial risks. Although stability is likely to be maintained, the government walks an increasingly fine line to do so. If tensions worsen between the United States and China, it is possible that China may be forced to choose stability over growth — a choice that would shake the global economy by stunting global demand.
Sara Hsu is Associate Professor of Economics at State University of New York at New Paltz.
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