FRBSF Economic Letter
2004-31; November 5, 2004
Reflections on China's Economy
Pacific Basin Notes. This
series appears on an occasional basis. It is prepared under the
auspices of the Center for
Pacific Basin Studies within the FRBSF's
Economic Research Department.
This Economic
Letter is adapted from remarks delivered to the International
Financial Institutions Association of California and the National
Association of Chinese American Bankers in Santa Monica, California,
on October 15, 2004.
Asia has been an important focus for
the San Francisco Fed for many years, in terms of both our supervisory
function and our research.
Therefore, like my predecessors, I traveled to the region recently,
spending several days in China visiting central bank officials,
members of economic and regulatory commissions, academic economists,
and local entrepreneurs.
A main topic of discussion was how China
can keep its economy from overheating, a concern that began to
emerge toward the end of 2003,
when GDP grew at a rate of around 10%. One key factor supporting
this growth has been investment, which grew at an average rate
of almost 17% over the last four years, exceeded 25% last year,
and jumped more than 40% over year-ago levels in the first quarter
of 2004. Another key factor is exports, which have been rising
at an annual rate of almost 30% in the last two years.
"Overheating" usually means that an economy is suffering from
excess demand, which then causes inflation to rise. In China, concerns
about excess demand are centered in sectors such as real estate,
cement, and steel, where investment has been so strong that government
officials and many outside observers are concerned about the development
of overcapacity, leading to a boom-bust cycle. A related concern
is that the bank lending that is financing these investments could
result in a new crop of nonperforming loans. With respect to broad
price trends, some officials argue that general inflation is not
a serious issue at this stage, even though it recently exceeded
5% on a year-over-year basis. They note that price increases are
concentrated in food and are due to poor harvests last year. Core
inflation has been near zero. Other observers, however, fear that
price inflation and shortages in some price-controlled sectors
like electricity portend more pervasive inflationary pressures.
Monetary
policy challenges
These conditions have set up some real challenges
for the policymakers at the People's Bank of China. First, they
want to slow the
economy enough to achieve a "soft landing," having
suffered through two "hard landings" (1985–1989
and 1992–1994), when growth dropped severely. In China, a "soft
landing" means bringing growth in at close to 7%, because
that rate is viewed as necessary to create enough jobs to absorb
surplus rural labor and workers laid off by state-owned enterprises.
China has the "potential" to grow rapidly.
Second, the government
has been trying to move not only toward a market-based economy,
but also toward market-based policymaking.
That would imply that the central bank would engineer a slowdown
by raising interest rates. However, its approach has been more
along the lines of directed controls. Although the government has
tried to slow the economy through higher reserve requirements and
liquidity tightening in the banking system, it also has used sector-specific
administrative measures intended to cool those industries I mentioned
earlier—real estate, cement, and steel—while allowing
the rest of the economy to continue growing strongly. This use
of directed controls rather than raising interest rates—or
revaluing the currency—raises questions about whether the
country's progress toward a market-based financial system
has slowed. [Editor's note: On October 28, as this article was in
press, China did, indeed, raise one-year benchmark lending rates
and deposit rates by 27 basis points.]
Third, controlling the money supply has been complicated
by China's policy of maintaining its exchange rate peg at its current
level
of 8.3 renminbi per dollar in the face of rapidly increasing foreign
investment inflows, especially over the last two years. Direct
investors have expanded their operations in China, and portfolio
investors have speculated on a currency revaluation, generating
so-called "hot money" inflows. To maintain the peg,
the central bank has intervened by selling domestic currency in
exchange for foreign reserves; as a result, the quantity of foreign
reserves has ballooned—it increased over $100 billion in
the last year—putting pressure on monetary aggregates and
inflation. So far, the central bank has managed to offset much
of this pressure through sterilization policies that soak up the
excess liquidity associated with the money inflows. But it's
not clear that sterilization will be effective in the longer term.
For one thing, China's domestic bond markets are relatively
shallow. For another, so long as the prevailing interest rate on
the bonds is so low, it may be difficult to attract buyers.
At
this point, it is unclear how successful China's efforts at slowing
the economy have been and whether the government will
resort to two broader-focused policy options—raising interest
rates or revaluing the currency. Both the central bank Governor
and the Vice Governor have discussed the first option, namely,
raising the base lending rate above 5.3%, the level that has prevailed
since 1995. In separate statements, these officials said that the
People's Bank would consider it if inflation exceeded 5%,
or if CPI growth caused a negative real lending rate. The CPI inflation
figures of 5.3% for July and August breached this threshold. More
recently, the Governor said that Chinese policymakers will decide
whether to raise interest rates soon after reviewing the August
economic reports.
Yet reluctance to raise interest rates appears
to remain for several reasons. First, insofar as policymakers believe
that much of the
inflation is attributable to food prices and that grain prices
are poised to decline, it is unclear to them whether higher interest
rates are needed to reduce inflation. Second, there are concerns
that higher rates would not necessarily significantly damp the
excessive investment in large industrial projects, which would
still be funded by state-owned banks; instead, higher rates might
stifle growth in well-performing sectors and squeeze credit to
smaller and medium-size private firms. Third, there is a concern
that higher rates would attract even more foreign "hot money" from
abroad, thus boosting money growth. Finally, higher interest rates
would lower the value of the government bonds held in bank portfolios,
harming their capital positions.
The second option—using
a revaluation as a macroeconomic tool to slow the economy by making
its exports more expensive—would
be consistent with the Chinese government's apparently genuine
desire to move to a more flexible exchange rate regime. And there's
plenty of speculation about whether the government will revalue.
But in the near term, it seems unlikely; instead, it's more
likely to occur as part of a longer-term strategy to reform China's
exchange rate management and capital control policies. For the
short-term, China has tried to ease pressure on the exchange rate
recently by imposing more controls on "hot money" inflows.
Reforming
China's financial system
A very important stumbling block along
the road toward market-based monetary policymaking—and a
precondition for liberalizing both capital flows and the foreign
exchange market—is massive
reform of China's financial system, and, in particular, its
banking sector. About two years ago, China separated the supervisory
functions from its central bank, creating the China Banking Regulatory
Commission. The Commission has had to tread a fine line between
improving bank conditions and not undermining the government's
economic growth targets or exacerbating social unrest—a tall
order, since curtailing credit to a state-owned enterprise could
lead to laying off thousands of workers.
The Commission is focusing
on three areas: improving the condition of the "Big 4" banks, restricting
loan growth, and overseeing the expansion of foreign banks in China.
The first area—improving
the "Big 4" banks—is also the Commission's
first priority. The banking sector's biggest problem is asset
quality—not surprising, given its historical relationship
with state-owned enterprises. The official aggregate nonperforming
loan ratio is now below 20%, but many analysts estimate that the
true level exceeds 40%. To put the size of the problem in perspective,
Standard & Poor's estimates that the full cost of writing
off these loans could be $656 billion, or about 43% of forecasted
2004 GDP. Given the government's ownership, this has become
a huge fiscal issue. Last January, the government recapitalized
two of the healthier "Big 4" banks, China Construction
Bank and Bank of China, injecting $22.5 billion into each institution
and enabling them to write down bad loans; however, as I said,
many have questioned the accuracy of reported asset quality improvement.
This
uncertainty has led to repeated postponements in the IPOs for these
two banks—the dates are now scheduled for 2006
or 2007. It's worth noting that the Chinese government appears
to feel that the main purpose of these IPOs is not to raise cash,
but to impose market discipline on bank management and on the government
itself to improve business operations and allow the banks to run
as commercial entities. Whether it will work is far from certain,
given that the government will retain majority ownership.
Second,
the Commission is restricting bank loan growth, which has been
dramatic over the past two years, topping 20% in 2003. Doing
so serves two purposes. First, it helps cool the economy through
higher reserve requirements and sector-specific lending moratoriums,
as I mentioned earlier. Second, it addresses the asset quality
problems created by aggressive expansion and lax underwriting.
The Commission is beginning to tackle the asset quality problem
by enforcing more stringent loan classification and underwriting
standards and by making it easier for foreign banks to buy distressed
loans. Together these actions have finally slowed loan growth in
the last few months.
Third, the Commission is preparing for the
2007 WTO deadline by eliminating most major financial sector trade
barriers. It's
widely known that many Chinese banks are ill-equipped to face the
increased foreign competition that liberalization will bring. Much
to its credit, the Commission is courting foreign institutions
to partner with Chinese banks as a way to provide financial support
and sorely needed technical expertise. A key example of this foreign
investment strategy is Hong Kong Shanghai Banking Corporation's
recent purchase of a $1.7 billion stake in the Bank of Communications,
China's fifth largest bank. HSBC expects to become involved
in helping BOCOM upgrade its risk management, internal control,
and IT systems.
Currently, foreign banks comprise only 2% of the
Chinese market, but they are targeting the best customers, the
emerging urban middle
class that is estimated to be 110 million people, roughly the size
of Japan's market. These customers can afford to pay for
more innovative financial services and want the expertise of foreign
banks to provide sophisticated investment products to plan for
a future without the traditional "iron rice bowl" social
welfare system.
Clearly, China faces several challenges in creating
a vibrant and fully privatized banking sector. I've already discussed
the
huge nonperforming loan overhang, and I'll highlight two
more. First is the simple lack of skilled personnel. People with
training in risk management and loan underwriting are scarce, since
it was impossible to gain such experience under the previous system.
Without these skills, it is unclear whether banks can pursue new
types of lending without significantly increasing credit risk.
The problems in recent growth portfolios, like real estate and
auto finance, cast doubt on potential success in the newest area
of expansion, consumer lending. And the prospect of interest rate
liberalization raises questions about bankers' ability to
price loans and deposits appropriately.
A more daunting challenge
is dealing with the country's political situation. Although the
policy consensus at the top is strong,
it won't be easy to overcome the considerable political power
at the provincial level and ensure that reforms actually "stick." Moving
to a market-based system means radically transforming the banks'
established role in the economy and will require a shift in power
and incentives.
In their historical role, the banks developed very close relationships
with state-owned enterprises and local governments, even closer
than their relationships with their own bank headquarters. For
example, hiring decisions for bank managers were typically made
by the local government, not by management at the bank headquarters.
These practices have led to corruption and poor corporate governance,
and local governments are not likely to relinquish their power
without resistance. Even if that happens, bank management may have
difficulty adjusting to an incentive system in which senior positions
and salaries are determined by performance, not rank or political
connections.
Let me conclude by giving you my overarching impression
from this trip. Even though these challenges are daunting, top
Chinese officials
are committed to continuing to pursue financial sector reform,
and they appear on track for WTO liberalization by 2007. We can't
lose sight of the fact that many of the changes the country has
made were unthinkable just a few years ago. So for the time being,
we have reason to be guardedly optimistic about the outlook for
the banking sector.
Janet L. Yellen
President and CEO
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