«The central government is willing to sacrifice growth in order to make sure that the financial stability issues do not get worse.»
Mr Liao, the whole world looked at the congress of China’s communist party. What is your take on this event?
We have not expected any major change of economic policies from the congress as its main purpose is to set the leadership for the next five years. But there are signs that the Chinese leadership continues to be concerned about financial risks. President Xi talked about continued efforts in corporate deleveraging and prevention of systemic financial distress in his speech. There are also some parts in his speech which hint on changing priorities in economic policy.
What were these hints?
Firstly, President Xi did not mention the official target to double the national income from 2015 to 2020. That reinforces our view that the government will be more flexible in reaching its growth target. It could give priority to deleveraging the economy. In the past, these two goals were at times at odds with each other. The second hint was that instead of pure material progress, Xi emphasized quality of life, which includes environmental protection. This could mean a big shift in the direction of economic policy. But for the details, we have to wait for the Central Economic Work Conference in December.
When discussing Chinese government policy, it seems that there is still a lot of uncertainty. When will policy predictability improve?
Actually, in some sense Chinese government policy is very predictable. For decades, the government has worked on dealing with legacies from the planned economy. There is an on-going process to transform the economy to be more market-based. This makes it predictable for the medium to long-term. And with the growth target of the government, also the short-term is quite predictable.
But where is the uncertainty then coming from?
What is not predictable is if the measures to reach the policy goals are in line with what many people in advanced economies would expect. In many cases, the Chinese government does not follow suggestions by foreign observers including the World Bank or the International Monetary Fund – for good and bad reasons.
Looking back, two years ago stock market turbulences in China spilled over to global markets. Could this happen again?
The underlying reasons for these turbulences were policy mistakes. The government wanted to initiate corporate deleveraging via an artificially propped up equity market. This mistake is unlikely to be repeated. But it is important to note that the turbulences were not a big deal for the Chinese economy as the stock market is comparably small. The effect was much stronger on the confidence of foreign investors who became weary of the Chinese markets. People outside of China were much more concerned, because in other economies the equity markets have a much more important role.
How do you assess the government’s economic reforms?
The government continues to strive for a balance between the two main objectives of growth and deleveraging. The current year is different to the previous years as there is a noticeably slower debt growth in the financial sector, including the shadow banking system. The reduction of the debt burden in the financial sector was stronger than in the corporate sector. Banks are still in the process of adapting themselves to the new policy setting by issuing less interbank loans. Corporate debt growth has also decelerated significantly since late 2016, but it is still faster than China’s nominal GDP growth. While debt growth is under control, we are not sure if the pace of deleveraging is fast enough. That is why we took a rating action in September by downgrading the sovereign as well as the banking industry.
A lot of debt was taken on by local governments. What development do you see in that regard?
The development regarding the local government financing vehicles makes us actually more hopeful. The central government took a more hawkish stance towards this borrowing. The Ministry of Finance made clear that the debts issued by these vehicles after 2015 should be regarded as corporate debts. And local government officials are now personally accountable for any incompliance with the rules for local government borrowing which were put in place over the last few years. These are signs that the central government is willing to sacrifice growth in order to make sure that the financial stability issues do not get worse.
There were news that the government want to provide better support for private companies. Is that happening?
There are strong directives by the government to the banking system to provide more credit to private small and medium enterprises, SME. The loan growth to the SME sector cannot be lower than the growth of the total loan book. This is a good signal. On the other hand, the reforms of the state-owned enterprises, such as merging companies, lead to a larger influence of these companies in the economy. It depends from which angle you look on this development.
Do banks really extend more credit to the private sector?
This is for sure. Apart from SME lending rule that we mentioned earlier, one reason is that the loan volume to the household sector increases at a much higher rate than loans to other sectors. Households use this money to buy property or for consumer goods. This also indirectly benefits private companies as they are more engaged in producing consumer goods.
Is the progress of economic reforms not disappointingly slow?
Everybody says that China should have less government intervention. But timing is very important. When the government implements drastic changes, it could be interpreted by the market as a panic move. This makes it very difficult for policy makers to implement such changes. We are talking about an economy which still is in the transition to a model where production factors would be entirely allocated by the market. The reason of policy uncertainty is not that the goals were not clear. But the government needs to manage this transition carefully. Having said this, if only baby steps are taken, nobody believes that real change is happening.
Is there not a problem of policy communication?
There are instances where the government clearly communicated policy measures, but nobody took the communication seriously. One example is the borrowing of the local government financing vehicles. The government made clear to the market that from 2015 on, this borrowing is to be regarded as non-government debt. Nobody really believed that such a change in paradigm happens. What can the government do then?
What would happen if such a financing vehicle would default?
If the central government were to allow such a default, it would be a big deal for the bond market. Such a decision would be a strong signal by the government that they take the paradigm change for the local-government debt very seriously. It would lead to a massive repricing of bonds and would weigh on economic growth in the short-term. Depending on the significance of the bond market adjustment, the market would probably think of it as a policy mistakes, even if in the long-term it could be beneficial for the economy.
Some people are worried about an overheated property market in China. Do you share their concerns?
Overall, housing affordability in China did not deteriorate significantly in the past 19 years. We don’t expect a big fall in property prices as there is strong underlying growth in demand. On a national level, real estate prices are high but not increasing relative to income. However, the market in Tier-1-cities such as Beijing and Shanghai is a very different story. The house prices compared to the income are much less affordable and there is more speculation involved.
If property prices in these Tier-1-cities would decrease, would banks suffer?
These new risky loans are only a small part of the loan book. And the high down payment requirements would reduce the banks’ credit losses in a property market downturn. The refinancing of existing mortgages, which could make seasoned loans riskier, is rare in China’s market. As a result, non-performing loans constitute now only 0.4% of the banks’ home loan book. Even if this rate would increase substantially, it would not be a big problem for the banking sector. The key risk remains with the corporate loan book because China’s corporate borrowers are heavily reliant on property or land as collaterals for loans and lower property price could constrain their refinancing capacity.