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IMF Executive Board Concludes 2016 Article IV Consultation with the People’s Republic of China
On July 27, 2016, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 with China.
China continues its transition to sustainable growth, with progress on many fronts yet also many challenges. Growth slowed to 6.9 percent in 2015 and is projected to moderate to 6.6 percent this year owing to slower private investment and weak external demand. The economy is advancing on many dimensions of rebalancing, particularly switching from industry to services and from investment to consumption. But other aspects are lagging, such as strengthening SOE and financial governance and containing rapid credit growth.
Inflation dipped below 1.5 percent in 2015 and is expected to pick up to around 2 percent this year, reflecting the rebound in commodity prices and the exchange rate depreciation since mid-2015. Infrastructure spending picked up and credit growth accelerated in the second half of 2015. Accommodative macro policies are projected to continue supporting activity over the remainder of 2016.
The current account surplus is projected to decline to 2.5 percent of GDP this year (from 3 percent of GDP in 2015) as imports increase and the services deficit widens with continued outbound tourism. The balance of payments came under pressure in 2015 due to large capital outflows, mainly related to repayment of external debt. The volume of outflows is expected to moderate this year. After appreciating 10 percent in real effective terms through mid-2015, the renminbi has depreciated some 4.5 percent since then and remains broadly in line with fundamentals.
Executive Board Assessment
Executive Directors commended the Chinese authorities for their strong determination to achieve more balanced, sustainable growth. They noted that economic growth continues to moderate and is driven increasingly by services and consumption. Directors welcomed the impressive progress on structural reforms in many areas, notably interest rate liberalization, internationalization of the renminbi, and urbanization. They also welcomed the 13th Five-Year Plan, with its ambitious goals centered on economic rebalancing.
Directors noted that China’s economic transition will continue to be complex, challenging, and potentially bumpy, against the backdrop of heightened downside risks and eroding buffers. They stressed the need for decisive action to tackle rising vulnerabilities; reduce the reliance on credit-financed, state-led investment; and improve governance, risk pricing, and resource allocation in the state-owned enterprise (SOE) and financial sectors. Directors emphasized that consistent, well-coordinated, and clearly-communicated policies are key to a smooth, successful transition, which will eventually benefit the global economy.
Directors highlighted the urgency of addressing the corporate debt problem through a comprehensive approach. They encouraged the authorities to harden budget constraints on SOEs; triage and restructure or liquidate over-indebted firms; and recognize losses and share them among relevant parties, including the government if necessary. Piloting a few SOEs would make a strong start to the process. Directors recommended that the authorities complement these measures with targeted social assistance for displaced workers, and initiatives to facilitate entry of new, dynamic private firms.
Directors concurred that macroeconomic policies should be geared at lowering vulnerabilities, which would likely entail somewhat slower growth in the short term. They welcomed the authorities’ intention to rely on fiscal support if growth falls sharply in the near term. To this end, they saw merit in using on-budget, pro-consumption measures, which would help promote internal and external rebalancing. Measures could include raising pensions; increasing social, education and health spending; providing restructuring funds; and cutting minimum social security contributions. Continued efforts are also needed to ensure full implementation of the new budget law, improve fiscal transparency, and modernize the tax system.
Directors underscored the importance of further enhancing financial stability. Priorities include encouraging banks to proactively recognize loan losses and strengthen capital ratios; enhancing supervisory focus on liquidity risk management and funding stability risks; and addressing vulnerabilities in shadow products. Directors also recommended a major upgrade of the supervisory framework to foster cross-agency information sharing and policy coordination, reduce the scope for regulatory arbitrage, and enhance crisis management capabilities. They looked forward to the forthcoming Financial Sector Assessment Program Update.
Directors noted the staff’s assessment that the renminbi is broadly in line with fundamentals, although the external position in 2015 was moderately stronger than consistent with fundamentals. They welcomed steps toward an effectively floating exchange rate regime and encouraged the authorities to build on this progress while carefully managing the transition, and with the support of a more market-based monetary framework. Directors supported a cautious approach to capital account liberalization that is carefully sequenced with the progress on exchange rate flexibility and financial sector reforms.
Directors encouraged the authorities to continue to improve data quality and policy communications, which would help reduce uncertainty, align expectations, and guard against market turbulence.
People’s Republic Of China – Staff Report For The 2016 Article IV Consultation
Context. China continues its transition to a sustainable growth path. Rebalancing has progressed on many dimensions, particularly switching from industry to services and from investment to consumption, but less on reining in rapid credit growth. Reforms have advanced impressively across a wide domain, but lagged in some critical areas, and the transition to sustainable growth is proving difficult, with sizable economic and financial volatility. Vulnerabilities are still rising on a dangerous trajectory and fiscal and foreign exchange buffers, while still adequate, are eroding. Outlook. The near-term growth outlook has improved due to recent policy support. But the medium-term outlook is clouded by continued resource misallocation, high and rising corporate debt, structural excess capacity, and the increasingly large, opaque, and interconnected financial sector. The apparent challenges in implementing a clear and decisive reform path add to concerns that China may exhaust its still-sizable buffers before the economy changes course sufficiently.
Strategy. While the challenges are still manageable, urgent action is needed to ensure they remain so by reducing vulnerabilities while supporting new, market-based growth. This means slowing credit growth by tackling its root causes—the pursuit of unsustainably-high growth targets, soft budget constraints on SOEs and local governments, the web of implicit and explicit guarantees, and excessive risk taking in parts of the financial sector—while maintaining macro stability. Key elements:
- Tackling the corporate debt problem, with a comprehensive plan and concrete action to harden budget constraints (especially on SOEs), restructure/liquidate weak firms, recognize and allocate losses, improve governance, and facilitate market entry.
- Adjusting macro policies for a moderate slowdown, by allowing growth to settle at a level consistent with sustainable macro policies, substantially slowing credit expansion and switching from off-budget investment to on-budget, pro-reform and pro-consumption fiscal measures.
- Guarding against financial risks, by boosting bank buffers, recognizing losses, improving funding resilience, reining in risks in shadow banks/products, and improving the supervisory framework and crisis preparedness.
- Continuing progress toward an effectively floating exchange rate regime, combining an overarching drive toward progressively greater market-determination and skillful short-term management to avoid excessive volatility.
- Strengthening transparency, especially in communications and data quality.
“The new normal means… a farewell to the unbalanced, uncoordinated and unsustainable growth model” (Premier Li, 2016). But the transition is proving difficult and bumpy.
Macro and policy developments
1. Activity slowed modestly through early 2016, shored up by accommodative policies, and rebalancing progressed (see Selected Issues; Figures 1 and 2).
- Supply-side indicators. Industrial production has moderated steadily, with a needed rotation from excess-capacity upstream sectors (cement, steel, glass) to more consumer-oriented manufacturing (autos, computers, home appliances). Service sector activity has remained strong, even after stripping out the outsized contribution from financial services. Supply rebalancing—the switch from industry to services—continued its trend traced over the period of the previous five-year plan (2011–2015).
- Demand-side indicators. Retail sales have remained strong on the back of steady growth in household income. Investment has stabilized following the recovery in real estate in recent months. Demand rebalancing progressed, with consumption accounting for two-thirds of growth in 2015 and 2016:Q1.
- Inflation remained well anchored. Core inflation has been stable around 1½ percent. Headline CPI inflation accelerated recently due to food prices. Producer price deflation is still sizable (though moderated recently), reflecting excess capacity in real estate and heavy industry, and weak commodity prices.
- Policy support. Benchmark lending rates were cut five times in 2015, and in the second half of the year, fiscal policy turned expansionary, infrastructure spending picked up (supported by policy bank lending and the local government debt/loan swap), and credit growth accelerated.
- External sector. Exports have been subdued, reflecting weak external demand and real exchange rate appreciation through mid-2015. But import volumes have been weak as well, in line with slower domestic demand growth (Box 1). Positive terms of trade effects lifted the current account surplus in 2015 to 3 percent of GDP, but the external accounts came under substantial pressure due to large capital outflows.
- Exchange rate. The real effective rate appreciated by close to 10 percent from mid-2014 through mid-2015 due to the (then) tight link to the U.S. dollar, and has declined 4½ percent since then. The renminbi remains broadly in line with fundamentals (Appendix I).
2. Reform progress continued on many fronts, especially in improving the monetary and fiscal frameworks, and supporting urbanization (Box 2).
- Monetary framework. Interest rate liberalization was formally completed and the PBC advanced toward an interest rate corridor centered on the seven-day repo rate (see Selected Issues). The more market-based fixing mechanism for the RMB in August 2015 and the greater reference to a currency basket from December 2015 have allowed more flexibility against the U.S. dollar. Together, these reforms help move China towards an independent, market-based, monetary policy.
- Fiscal framework. A wide range of reforms are underway: the new budget law is being implemented (aimed at improving transparency and accountability of local government finances); the VAT extension to services was completed; a carbon emission trading scheme (the largest in the world) will be rolled out nationwide in 2017; social security reforms to unify pension schemes for urban/rural residents and public/private employees were announced, as was a review of revenue and spending responsibilities across levels of government (which should help address the large vertical imbalances that currently limit local governments’ ability to implement social spending reform).
- Urbanization. The government has continued to encourage rural residents to settle in urban areas—key for boosting productivity through specialization and knowledge spillovers—including by advancing rural land reforms, allocating basic public education spending to the central budget and improving the portability of pensions. Several provinces are rolling out a new household registration system whereby migrants can gradually qualify for basic social welfare and residency benefits.
- Corporate restructuring. The restructuring of unviable “zombie” state-owned enterprises (SOEs) has begun on a small scale at the local level, led by provinces with relative strength in public finances and more diverse economic structures.
3. The government adopted a new five-year plan (2016-20), centered on rebalancing the economy. It aims to boost consumption, expand the service sector, protect the environment, further open up the economy, expand public services, and reduce poverty. The government has also announced elements of a reform plan for SOEs and capacity reduction targets in the coal and steel sectors (10–15 percent of existing capacity over the next 3?5 years), together with a RMB 100 billion restructuring fund to re-employ and resettle an expected 1.8 million affected workers. However, in many areas, especially SOE reform, more details and guidelines are awaited.
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