Andrew Sheng & Xiao Geng: Channeling China's animal spirits

The People's Bank of China (PBOC) has cut interest rates for the third time in six months, in order to lighten the debt burdens of companies and local governments. But the PBOC's monetary easing - accompanied by complementary fiscal and administrative adjustments - has done little to increase demand for new loans. Instead, it has triggered a sharp rise in China's stock markets. The question now is whether that could turn out to be a very good thing.

There is little doubt that China's economy is shifting gears very quickly. Official statistics show a slowdown in real growth in the old manufacturing and construction-based economy, reflected in declining corporate profits, rising defaults, and an increase in non-performing loans in poorer-performing cities and regions. Meanwhile, the government's policies to tackle corruption, overcapacity, excess local-government debt, and pollution have put downward pressure on investment, consumption, and the government's capacity to deliver its promised growth rate.

With harder budget constraints imposed by the central government, local officials and state-owned enterprises (SOEs) have curbed their spending on investment, and are now being overly cautious. In the short run, this restructuring could lead to localised balance-sheet recessions, despite the authorities' efforts to create a more accommodating macroeconomic environment.

The private sector, by contrast, is picking up steam, with recent administrative reforms having contributed to a 54 per cent rise in business registrations since March 2014. Increased innovation and the rise of the services sector have helped China move beyond its role as the world's factory to develop its own version of the Internet of Things, driven by platform companies like Alibaba and Tencent.

Some 14.3 million new stock-market trading accounts were opened in China last year. And the PBOC's interest-rate cuts, together with reductions in banks' mandatory reserve ratios, have fueled a rise in the Shanghai, Shenzhen, and ChiNext indices of 95 per cent, 198 per cent, and 383 per cent, respectively, since January 2013. Chinese stock-market capitalisation grew from 44 per cent of GDP at the end 2012 to 94 per cent of GDP earlier this month.

This has important potential implications - both positive and negative.

On the positive side, the revival of China's stock market in a low-interest-rate environment represents an important shift in asset allocation away from real estate and deposits. Roughly 50 per cent of Chinese savings - amounting to as much as half of GDP - lie in real estate alone, with 20 per cent in deposits, 11 per cent in stocks, and 12 per cent in bonds. To compare, in the United States, real estate, insurance, and pensions each account for about 20 per cent of total savings, with 7.4 per cent in deposits, 21 per cent in stocks, and 33 per cent in bonds.

Rising stock-market capitalisation also helps to reduce the real economy's exposure to bank financing. The US is much more "financialised" than China, with stocks and bonds amounting to 133 per cent and 205 per cent of GDP, respectively, at the end of 2013. Those ratios were only 35 per cent and 43 per cent, respectively, in China. Meanwhile, China's bank assets amounted to 215 per cent of GDP - more than double America's 95 per cent.

Finally, China's surging stock prices increased net wealth by CN¥37 trillion ($6 trillion), equivalent to 57 per cent of China's GDP, in just 18 months. If stock prices can be sustained, the implications for consumption, liquidity, and leverage will be profound. Smart households and entrepreneurs could take profits and reduce their debts. Similarly, both private enterprises and SOEs could use market buoyancy to raise equity to fund new investments.

But the rapid run-up in equity prices also carries considerable risks - namely, the possibility that the financial sector will misuse the newfound liquidity to finance more speculative investment in asset bubbles, while supporting old industries with excess capacity. That is what happened in 2008-2009, when a run-up of the Shanghai index (which reached 6,092 in October 2007), together with the government's CN¥4 trillion stimulus package, sustained overcapacity in traditional industries. Most of the credit went to real estate and local infrastructure projects, effectively reinforcing the most problematic trends in China's economy.

This time, one hopes, will be different. But even if Chinese retail investors begin to channel their money toward innovative ventures, identifying the companies and industries most likely to succeed will be difficult.

In the US, the collapse of the tech bubble in 2000 entailed a $4 trillion loss in market capitalisation. But the US managed to avoid a systemic crisis. If China's animal spirits are allowed to operate through market mechanisms, distinguishing real value from aspirational prices, China, too, can stay the course toward the new economy, despite the failures and consolidation that will inevitably occur.

As China's animal spirits are channeled, they will increasingly test the authorities' resolve to resist price intervention, instead allowing market forces to propel the business cycle. This will not be easy, given that the PBOC has plenty of additional room for monetary easing.

Indeed, at the end of last year, China still had CN¥22.7 trillion of statutory reserves, amounting to 36 per cent of GDP, that had long been used to "sterilise" its large foreign-exchange holdings. Such "locked liquidity" can be returned to the market in the form of new bank credit or new equity.

That is why the real test of China's administrative reforms is whether, through improved bankruptcy mechanisms and regulations that block fraud and market manipulation, they allow - and even facilitate - the effective functioning of market forces. With animal spirits - not the authorities - guiding it, China can build the high-value-added, high-tech economy it needs to compete in the future.
Andrew Sheng is Distinguished Fellow of the Fung Global Institute and a member of the UNEP Advisory Council on Sustainable Finance. Xiao Geng is Director of Research at the Fung Global Institute.

Copyright: Project Syndicate, 2015

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