Failure to tackle deleveraging task in China will only lead to greater pain

By Li Xunlei Source:Global Times Published: 2017/5/22 23:28:40

No easy answers as China tackles deleveraging

Illustration: Peter C. Espina/GT

With China currently facing the urgent tasks of tightening financial supervision and clamping down on financial leverage, there is a need to learn from the experiences of the Japanese and US economies in handling deleveraging.

At the mention of the Japanese economy, people instantly think of the bursting of its asset price bubble and the subsequent "lost" 20 years. The Japanese financial and non-financial sectors have continued deleveraging for more than 20 years. It has been a tortuous process, and there is no sign of a strong rebound in the country's economy.

In comparison, after the 2008 subprime mortgage crisis led to the economic hard landing in the US, the US government helped businesses and households deleverage by taking on debt, and it only took seven years for the US economy to get back onto a path toward strong recovery. According to the current economic indicators, its deleveraging has been successful, with the country now enjoying a low unemployment rate, stable inflation and relatively fast economic growth.

Different countries have seen different outcomes from deleveraging. In the US, vigorous deleveraging came at the cost of an economic hard landing, but it was also highly efficient in the sense that the market was quickly cleared so as to allow for reallocation of resources, facilitating rapid economic recovery.

China is under severe pressure to deleverage. Debt among non-financial businesses has soared rapidly in recent years, to account for 162.8 percent of GDP in 2015, up from 106.5 percent in 2006. If China gets its deleveraging strategy wrong, it may risk repeating Japan's lost decades.

There are also various obstacles facing China's deleveraging efforts. For instance, as the asset price bubble has yet to burst, various interested parties will try to impede policymakers from deleveraging in an effort to avoid loss of their benefits.

While financial institutions have felt the pressure of deleveraging with the tightening of regulatory scrutiny in recent days, the bottom line for the Chinese government is to ensure steady growth and avoid a systemic financial crisis. Therefore, we cannot adopt the US approach of quickly clearing the market. But allowing leverage to continue to climb may put China in the same position as Japan; that is, the debt burden could become so heavy, it would take non-financial enterprises a long time to recover.

In our opinion, deleveraging is an important part of economic structural reform and is necessary. But in terms of implementation, it is crucial to know where we should deleverage, or whether to keep the same leverage ratio or even increase leverage slightly in some areas. A basic conclusion would be that China should increase leverage for government departments, deleverage financial and non-financial enterprises and keep household leverage stable.

First, the ratio of China's government debt-to-GDP was 39.4 percent in 2015. If including the debts that local governments had guaranteed or were partly obligated to pay, the ratio would have been about 41.5 percent, and the figure is expected to exceed 50 percent in 2020. That would still be below the EU's warning line of 60 percent, and also lower than the level of other major economies around the world.

As such, China's current government leverage is not excessively high compared with that of developed countries, but given the country's economic and social development stage, it is relatively high. Moreover, with the population aging, the government's fiscal spending will have to surge accordingly, which means that the leverage ratio will grow further.

Second, the leverage ratio of China's non-financial enterprises is among the highest in the world, and is more than twice the level of the US.

In addition, deleveraging is also necessary for China's financial enterprises. The financial sector has contributed too much to China's GDP, reaching up to 8.3 percent in 2016 and exceeding the corresponding levels in the US, Japan and the UK. In fact, deleveraging of financial institutions could also facilitate the deleveraging process at enterprises and government departments, especially State-owned enterprises and local governments. For instance, last year, the banking industry witnessed an increase in its total assets, among which a large part are liabilities of State-owned enterprises and local governments.

Based on international experience, if the economy doesn't go through a hard landing, it is very difficult to lower leverage ratios across the board. In the case of China, we want to stabilize growth to ensure sufficient employment. This requirement makes it hard to slow down investment growth, and therefore lowering enterprises' leverage ratio is also extremely difficult. Moreover, if there was a stock market crash or some other crisis, financial institutions would have to relax their deleveraging process under the resulting pressure. It should be clear that any delay to the deleveraging for the purpose of seeking a so-called "painless cure" for the Chinese economy would only lead to even greater pain.

The author is chief economist with Zhongtai Securities.

Newspaper headline: No easy answers as China tackles deleveraging

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