China’s growth has witnessed increasing momentum. Growth picked up since late 2016, reaching 6.9 percent for the first half of 2017, with inflation well-anchored at 1.4 percent and 7.35 million new jobs added. The effects of structural reform to reduce overcapacity, leverage, and inventory on the supply side have unfolded. In the first half of 2017, consumption contributed 63.4 percent of GDP growth; the growth of the service industry continued to outpace that of the manufacturing industry and accounted for 54.1 percent of GDP. Structural reforms on the supply side have seen encouraging progress, reflected in a rise of capacity utilization in the industrial sector by 3.4 percentage points to 76.4 percent, a decline in the liability/asset ratio of the industrial sector by 0.7 percentage points to 56.1 percent (y-o-y), and a drop of housing inventory by 9.6 percent (y-o-y). Overall efficiency of the economy has improved continuously, with industrial enterprises registering a 22.7 percent growth of profitability in the first five months of 2017, 16.3 percentage points higher than the same period of last year.
China continues to emphasize the quality and sustainability of growth rather than high growth figures. The Chinese authorities are no longer aiming at a single target of GDP growth, but are pursuing a new development modality that focuses on quality and sustainability, and encourages innovation-driven, harmonized, green, open, and inclusive development. We are determined to seize every opportunity to realize the potentials. The stronger performance since 2017 was not merely driven by policy stimulus, but rather, a reflection of rebalancing and structural adjustment, supported by a rebound in the business cycle against the backdrop of a stronger global recovery. Foreign trade has registered a growth of 19.6 percent in the first half of 2017 (y-o-y), with imports growing 10 percentage points higher than exports.
Going forward, we are confident in sustaining the growth momentum, and an abrupt slowdown is very unlikely. The staff’s scenario of an abrupt slowdown of the Chinese economy, in our view, is highly unlikely. The authorities’ ongoing efforts can mitigate the downside risks in the economy. Specifically:
- The reform of the regulatory system announced by the recently concluded Financial Conference will address the potential vulnerabilities in interbank funding and wealth management activities. Furthermore, the strengthened central bank has adequate facilities and policy buffers to ease any liquidity shocks on the market.
- More active embrace of free and open trade, through both bilateral and multilateral initiatives, including the “Belt and Road” initiative, would largely offset the risks of trade tensions caused by the inward-looking policies of some trading partners.
- Greater exchange rate flexibility in line with market fundamentals, with a reference to a basket of currencies rather than a single currency, would function as an important buffer to avoid disruptive volatilities, and these efforts will be supported by prudent capital account management and CFMs, when necessary.
Notable progress has been made in corporate sector deleveraging. Staff’s recommendations on mitigating financial risks and deleveraging are in line with the policy objectives of the authorities. The authorities have been paying great attention to the prevention and mitigation of financial risks, particularly since the second half of last year. Efforts to lower high leverage ratios in the corporate sector have been effective. Compared with the same period of the previous year, the growth of overall leverage in 2016 slowed by 7 percentage points, and that of the corporate sector slowed by 9.2 percentage points. It is noteworthy that leverage in the corporate sector declined in Q3 of 2016, the first time since 2011, and stabilized in Q4. If compared by combined direct and indirect financing as a share of GDP with major economies, China does not seem to be outstanding. The relatively high leverage is a structural issue, as 80 percent of China’s financing need is covered by banks. The leverage in the past several years should be viewed as countercyclical, which is desirable. Nevertheless, further scrutiny is warranted on the structure of leverage, as leverage in the household sector and the public sector remains much lower than the global average.
Monetary policy remains sound and tilted to a more neutral stance, reflected in rising interest rates on the money market and slowing monetary supply. The recently concluded Financial Conference has stressed that monetary policy should remain sound and strike a balance among boosting growth, facilitating structural adjustment, and managing aggregate social finance. By end-June, M2 growth slowed by 2.4 percentage points to single digit, 9.4 percent, and M1 growth plunged even further by 9.6 percentage points to 15 percent, compared with last June. China will deepen its market-oriented exchange rate reform and rely more on market forces to determine the exchange rate.
The concept and estimation of “augmented” debt and deficit may be a prudent approach from staff’s perspective, but is highly debatable under China’s circumstance. The adoption and firm implementation of the new budget law, a nationwide clean-up of implicit local government debt through Local Government Financing Vehicles (LGFVs), and standardizing and capping local government financing have quantified the size of public debt, strengthened local public debt management, and hardened the budget constraints of local governments. The recent Financial Conference has explicitly announced a “lifetime” accountability for decision makers of local government borrowing.
We have a different view on the “augmented” concept in the staff report, which prefers to define government debt based on the purpose of the borrowing and presumed government backup, rather than on actual and legal repayment liabilities. Staff’s approach to debt analysis is useful in keeping us vigilant to potential risks associated with the “augmented debt.” But ignoring country-specific institutional setup could cause exaggerated fiscal vulnerabilities and underestimated long-term growth.
A different debt structure and saving ratio of a country could imply different debt sustainability even at the same debt/GDP level. In China, local government debts are mostly used to finance infrastructure construction, which would be transformed into tangible assets and returns. They are productive and hence self-sustainable, compared with debt raised for current spending in many other countries. More generally, as a provider of public goods, the local governments have taken the lead to promote infrastructure investments that are usually cross-regional and may have little or moderate financial return but high economic return and positive externalities to the overall economy in the medium and long term. This has proven to be an effective strategy to overcome market failure that causes the lack of incentives for private investors. It is one of the valuable experiences of China’s economic development, and a rational choice to tap the high national savings and meet the challenges of the aging population. It is necessary and consistent with the need to boost domestic demand, narrow the saving/investment gap, and therefore achieve external rebalancing. Taking into account China’s large public asset, the net public debt is much smaller than the nominal debt. Partial interpretation of this kind of productive debt could lead to a bias or error in assessing the economy.
Financial regulation and supervision
Financial regulation will be tightened and enhanced in a holistic fashion. The recently concluded Financial Conference has reiterated the high priority of preventing and mitigating systemic financial risks, enhancing financial safety net, and developing contingent plans of risk resolutions. The Conference has drawn a blueprint for the financial sector to better serve the real economy, prevent financial risks, and deepen financial reforms by establishing the Financial Stability and Development Committee of the State Council. The central bank’s role on macroprudential management to mitigate systemic risks has been significantly strengthened. The Committee will set up its coordination office in the central bank. The accountability of the regulatory authorities will also be strengthened. The Conference highlighted the importance of professional, unified, and cross-cutting supervision, aimed at a complete coverage of all financial activities. Function regulation would be strengthened with more behavior regulation to identify and mitigate risks on a timely basis. That said, given the high savings ratio, large foreign reserves, and adequate capital, required reserves and provisioning in the banking sector, supported by the recently established deposit insurance scheme, we are confident that financial risks are manageable.
SOE reform has been a high priority in our reform agenda. Over 80 percent of central SOEs in China are listed holding companies, and subject to commercial principles. Banks make decisions based on independent and commercial judgment when lending to SOEs. Significant progress has been achieved in strengthening the corporate governance of SOEs and in enhancing their efficiencies. As a result, SOEs have been growing at the same pace of the economy, playing a significant role in underpinning the growth and development of the economy. SOEs under the central budget have registered double-digit growth of revenues and profits since 2003. Fifty SOEs are listed in the “Fortune 500” and three SOEs are among the top 5. Strong performance of SOEs does not necessarily mean they are dominant, because the private sector is now a more dynamic driving force of the economy, providing over 80 percent of employment, 60 percent of GDP, 50 percent of tax revenue, and 89 percent of export.
It would be oversimplified to assess the value and efficiency of SOEs only by its financial returns, and it is not fair to blame them for the high consumption of resources and low efficiency. In fact, due consideration should be given to the social and policy responsibilities they have assumed; their high borrowing from the banking sector not only shows their reliance on debt financing rather than equity financing, but also implies their stable and large interest payments to the banking sector. SOEs also have made much higher contribution to tax revenue and social stability.
Going forward, the authorities will focus more on containing the excessive leverage of some SOEs, and preventing and reducing inappropriate monopoly. The Financial Conference has highlighted the deleveraging of SOEs and elimination of Zombie firms as top priorities. The SOE reform will accelerate and the overall efficiency of the economy will be continuously enhanced.