May 24, 2017
In recent months, the international economic debate has focused attention on the implications for trade and world economic growth of the arrival of Donald Trump to the presidency in the United States. On a daily basis, there are scenarios regarding the effects of a possible tariff trade war between the US, Mexican and Chinese economies, to mention a few, and the threat of dismemberment of the European Union as a result of Brexit and the popularity of extreme right and left political movements gaining ground in France and Greece, among other European countries.
However, and without intending to lessen the current global political-economic outlook, most analysts have overlooked an element of great importance to global economic stability and that could trigger some of the concerns mentioned above: the situation of China’s financial system and its implications for global economic stability.
For a decade, the Chinese economy has been adjusting to a new growth standard. After surpassing growth rates of 14% of GDP in 2007, it has experienced economic growth rates of 7.7% in 2012 and 6.7% in 2016. By 2017, forecasts indicate that the Chinese economy will grow 6.6% of GDP (see Figure 1). To counteract the decline in economic activity, the Chinese government took a series of measures to expand domestic demand through credit expansion and the construction of housing and infrastructure megaprojects. Some of these measures were taken at the same time as a reform was introduced to make flexible the exchange market with the aim of the yuan being considered as reference currency within the IMF basket, a process that culminated in September 2016.
Unsurprisingly, the Chinese economy has been responding to adjustment. Since 2014 the Chinese yuan has maintained a steady depreciation trend against the US dollar, despite the fact that monetary authorities of the People’s Bank of China (PBOC) have made significant intervention efforts in the foreign exchange market (Figure 2). The injection of foreign currency to support the yuan has been of such a magnitude that PBOC reserves have declined at an annualized rate of 9%, reducing the stock of reserves by almost 25% between June 2014 and February 2017 (see figure 3). As a result, the PBOC ceased to be the largest US bond holder, relegating that position to the Central Bank of Japan, reducing its bond stock to just over US$1 trillion (Figure 4).
The theoretical models developed by Robert Mundell (Nobel Prize for Economics in 1999) refer to the existence of a trilemma, or impossible trinity, when the authorities want to control the exchange rate, maintain an independent monetary policy and allow the free capital inflow. For this reason, the PBOC authorities chose to introduce new measures to restrict capital inflows. As professor Carmen Reinhart (Harvard University) noted, these efforts “often end poorly”.
The weakening of the POBC international reserves and the devaluation pressures on the yuan take place in an environment of financial stress due to the high level of indebtedness of the corporate sector and the observed increase in the indicators of bank delinquency. That is, to counteract the weakening of the economy and the decline in output, China took a series of expansive monetary and fiscal policies in order to boost aggregate demand. Following the international financial crisis of 2009, the Chinese government introduced a fiscal package equal to 12% of GDP. At the same time, credit growth averaged 20% in the period 2009-15, which is more than double the average nominal GDP growth. As a result, the consolidated public and private debt increased from to 247% of GDP, with two-thirds of this debt (156% of GDP) held by the corporate sector (Figure 5). That is, the corporate debt estimated to 2016 is US$17 trillion—about the size of USA GDP!—and this figure does not include bank loans classified as “investment receivables”, which constitute a kind of asset that allows banks to make little or no provision for potential losses. To better understand the challenge of chinese authorities, the IMF’s Global Financial Stability Report of April 2016, for example, estimated loans “potentially at risk” at 15.5% of total loans to the corporate sector, suggesting that potential losses on these loans could reach up to 7% of GDP.
Finally, all this brings us to the international environment. The way the Chinese authorities face the problems of the financial system is yet to be seen. Some measures, including the use of currency derivatives, have been implemented to lessen the decline in reserves. Authorities should weigh the decision whether to let the currency float further or avoid declining reserves, so that they may have room to solve the challenges of the financial system. A massive bankruptcy of the financial system would not only have consequences in the Chinese economy, but would also create major disruptions in the global debt market. This, in turn, could throw into the abyss economies that, like Greece—perhaps already gone!—or Italy, are heavily indebted and dependent on international financial aid for their governments to operate minimally.