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China tries to find equilibrium

Beijing is faced with a number of headwinds in its financial system. It will be a challenging balancing act.

Beijing is faced with a number of headwinds in its financial system. It will be a challenging balancing act.

John Redwood

in Features


China is seeking to balance a series of difficult pressures. There is the problem of weak banks and plenty of bad debts in the system. There is the wish to speed transition from reliance on industry to faster growth of technology, communications and consumer services. There is the need to reform and open up its financial markets more, and to edge towards a more market driven way of fixing interest rates and exchange rate. Abroad China has to battle against Trump tariffs and criticisms whilst avoiding a provocative devaluation of the currency.

China’s main way of regulating its money and loan growth is through the Required Reserve Ratio it applies to regulated commercial banks. Since 2018, there have been seven cuts in this ratio to seek to stimulate more lending. If a commercial bank needs to deposit less by way of reserves it has more scope to lend from its own balance sheet. The Chinese Central Bank is not using its balance sheet in the way the Fed or ECB use theirs to inject more cash into their markets. The biggest item held by the Chinese Central Bank as an asset is the large foreign exchange reserves, not a portfolio of state debt in the way the USA and the Euro-area now do.

Small steps

The authorities are embarked on moves towards competitive commercial banks having more influence over interest rates, through their active participation in money markets in forming the Loan Prime Rate. China is widening the number of competitors and seeking to remove any official floor to the rates. So far this has resulted in small steps downwards, as the state encourages some modest cheapening in the price of credit. The state is well aware of weak banks in the system and has recently intervened to take over Baoshong Bank to achieve an orderly resolution of its problems. At the same time the Central Bank injected cash into markets to avoid any contagion from the Baoshong experience. It has changed the rules on perpetual bonds as a means of weaker banks raising new Tier One capital. Nine have done so and 17 are planning such actions.

The aim is to grow credit quickly to small and medium-sized enterprises and to the wider private sector in the newer areas of technology and consumer facing activities. Industry is being slimmed as older plants are closed, excess capacity removed and bad debts gradually tackled. The Bank’s mantra is to fight three battles, “preventing and diffusing financial risks, targeting poverty alleviation and controlling pollution”. It does so against an unhelpful world background, with “downward pressures” at home and abroad increasing.

The People’s Bank also sets out the requirements placed on it by the State Council. It identifies three tasks of serving the real economy, forestalling financial risks and deepening reforms in the financial sector. The Bank rules out “flooding” the market with liquidity, and a housing stimulus. It aims to keep money growth at around the levels of nominal GDP growth, or around 8.5% currently. It acknowledges that CPI inflation is currently too high, mainly owing to the shortage of pork from swine fever and the consequent rapid inflation in food prices which has hit family budgets. There is no producer price inflation to worry about in industry.

Exports still rising

The trade war has been an unhelpful narrative, affecting world markets. Despite the US tariffs China has still increased her exports over the last year and has boosted its trade surplus. One of the prime targets is to increase trade with the Belt and Road countries that China supports with investment and closer ties.

The corporate bond market is experiencing more defaults this year, as the authorities allow markets to discover that some state enterprises and institutions do not carry a government guarantee of their debts. Despite this, there has been some increase in the use of bond issues to finance the wider economy.

China is engaged in a long-term process of tidying up bank balance sheets, reducing bad debts and edging towards a more market-oriented approach to rate and asset price formation. At the same time, the big task is to move from dependence on industry to more consumption and services. There is a big need to cut reliance on coal and other fossil fuels. There is no scope for a major stimulus, and a difficult balance to be struck over structural change and its financing. We anticipate slower growth continuing, with occasional worries about the scale of the changes needed. Meanwhile US hostility to the way China controls her markets and still has such a dominant state sector will continue. This all points to discount valuations for Chinese shares.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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