What Is China’s Deleveraging Strategy?

China has been the fastest growing economy in the world for the past few decades. The Chinese economy continued to grow even during the recession period. Many economists believe that a growing Chinese economy was a gift to other countries during the slowdown. Since the Chinese economy was growing, international trade was flourishing, and other economies didn’t fare as badly as they otherwise would have. The remarkable growth that China has achieved during the past decades and even during the recession is believed to be fuelled by copious amounts of debt.

However, Chinese policymakers are now of the opinion that they have taken on too much debt. Hence, there is a need to reduce debt, i.e. to deleverage. The big challenge with deleveraging is that it needs to be done without causing any harm to the growing economy. China wants to right size its debt. However, it does not want to sacrifice growth in the process.

In this article, we will have a closer look at the debt situation in China and the strategy being adopted by Beijing in order to deleverage the economy.

The Opaque Debt Numbers in China

One of the biggest problems with the Chinese economy is that the numbers tend to be opaque. In the absence of precise numbers, it is difficult to understand the underlying situation and create policies. Let’s understand this with the help of an example.

Firstly, we need to understand that Chinese banks face a lot of regulatory restrictions. Hence, they tend to use roundabout ways of making loans. For instance, let’s assume that a company wants to borrow 1000RMB from Bank A. Bank A is willing to make the loan. However, existing regulations do not allow such loans.

In such a situation, bank A buys some sort of financial product from another bank B. This bank B will then use the proceeds to purchase some securitized assets from another party C. This trust selling securitized assets is not a bank and does not need to comply with banking regulations. Hence, it can lend RMB 1000 directly to the company.

The bottom line is that, instead of bank A directly lending to the company, it had to involve 3 more parties. This means that as a regulator if I look at the total loans due it will appear to be RMB 4000 whereas in reality the same RMB 1000 is owed by all parties to one another! This makes the numbers opaque. The end result is that Chinese officials have no clue about how much leverage is present in the economy!

In order to correct the problems of this opaque system, China has decided to crack down on this shadow banking system. This is one of the major ways in which the Chinese economy is deleveraging. Also, this move is likely to make the credit system more efficient. There is no need for multiple commission-seeking agencies to be involved which making every single loan. This only increases the cost of credit which hurts the Chinese economy in the long run.

The Focus on Private Consumption

The Chinese think-tank has come to the conclusion that it is not the debt which is the problem. Instead, they believe that the way in which the debt is structured is the problem. For instance, most of the growth in China has been the result of centralized planning. This means that the debt has also been borne by public companies.

The Chinese consumer, on the other hand, has a lot of savings. Instead, the Chinese consumer has the largest savings rate in the entire world. This means that they are in a position to take on more debt if required. There will be less risk of bankruptcy or insolvency given the fact that the fundamentals are strong.

The Chinese deleveraging strategy is, therefore, a plan to deleverage state-owned enterprises. On the other hand, they want to bring about a culture of consumption in their middle class. If China is able to do both these things simultaneously, then it will successfully reduce the rate of default while at the same time there will be little to no effect on the growth rate of the economy.

The Challenge

China had successfully started deleveraging its state economy. However, Donald Trump started his trade war. This is particularly bad news for Beijing’s future plans. Beijing has always depended on the export-led growth as the main driver of the economy.

The United States has been the biggest consumer of Chinese goods. However, now it seems that the Chinese products will attract tariffs in America. Hence, the demand for these products is likely to slow down. To counter this slowdown, Beijing will have to increase the supply of credit to its own industries.

China has already started reversing its deleveraging policy. For instance, it has cut the reserve requirements. This means that the banks now have the ability to give out more loans.

It will be interesting to see how China adjusts its strategy to ensure that they can deleverage without affecting growth. However, that may only happen in the long for. For the moment, it seems that the current deleveraging strategy has been brought to a halt.