Towers in financial district, Shanghai, China. Economic activity in China has become too reliant on investment and credit, says the IMF (photo: Kohls/Imagebroker/Corbis)
Economic Health Check
In their annual report on China’s economy, the economists emphasize the importance of reforms to secure more consumer-based and sustainable growth going forward.
Progress on external rebalancing, with rising domestic vulnerabilities
The resilience of China’s economy since the 2008 financial crisis has provided a welcome boost to global demand, and substantial progress has been made in rebalancing China’s external accounts, says the report.
But it warned that the pattern of economic activity in the world’s second largest economy has become too reliant on investment and credit, resulting in rising domestic vulnerabilities in the financial sector, local government finances, and real estate.
The Chinese authorities have announced a broad range of reforms and policy objectives for 2013 that are intended to contain risks and rebalance growth, but the priority now should be to devise specific action plans and implement them swiftly, says the report.
This will ensure a smooth continuation of the historic transformation of the past three decades in which bold reforms have helped China generate rapid growth and lift more than 500 million citizens out of poverty, it adds.
Nontraditional finance and the risk of credit crunch
Citing the rapid expansion of credit, the report cautions that while the development of nontraditional finance in the form of trust and securities companies marks a shift to more market-based intermediation, the migration of activity to less regulated parts of the system poses risks to financial stability. Banks remain closely linked to the development of nontraditional finance. The report noted that any worsening of credit quality related to the boom in nontraditional finance could potentially lead to a credit crunch and a large fiscal burden.
The expansion of nontraditional finance has accompanied a build-up in borrowing by local government through off-budget financing vehicles, particularly since 2009. Broadening the definition of government to include local government financing vehicles (LGFVs) and off-budget funds, the report estimates that in 2012 the “augmented” government debt was 45 percent of GDP (roughly double the headline general government debt figure) and the “augmented” fiscal deficit was around 10 percent of GDP (compared to a reported headline fiscal deficit of 2 percent). The report noted that fiscal space based on the augmented debt figure is more limited than headline data suggest.
“While the size of augmented government debt and overall government resources suggests that fiscal challenges are currently manageable, further rapid growth of financial sector exposures to LGFVs would increase the risk of an eventual disorderly adjustment,” said Markus Rodlauer, the IMF’s mission chief for China.
Strengthening fiscal management
The report says that the growing vulnerabilities in local government finances stem from a mismatch between expenditure mandates and revenue sources. A by-product of this is local governments’ reliance on land sales for financing, which creates distortions in the real estate market—the third category of domestic risks examined by the Fund team.
The report noted that the measures put in place to limit real estate credit and speculative demand have helped, although price growth has picked up again recently. The real estate market remains prone to price run-ups underpinned by demand for housing as a vehicle for savings and store of wealth.
“The challenge for China now is to accelerate its transition to a more balanced and sustainable growth path with a decisive new round of reforms that address the growing risks in various parts of the economy and unleash new sources of growth,” said Rodlauer.
Reforms for continued success
The report emphasizes a more market-based and liberalized financial system as critical to prevent a further build-up of risks, achieve a more efficient allocation of investment, and boost household capital income.
The priorities are to liberalize interest rates; strengthen regulation and supervisory oversight; establish a robust, transparent framework for resolving bad debts and troubled financial institutions, which will help root out the widespread perception of implicit guarantees on most loans; and move to using interest rates as the primary tool of monetary policy.
Beyond the financial sector, the report outlines a range of additional reforms to strengthen governance, liberalize the economy, and rebalance domestic demand— opening markets to more domestic and foreign competition, especially service sectors and upstream industries currently reserved for state-owned enterprises (SOEs); raising resource prices and taxes to rationalize investment and protect the environment; increasing the dividends SOEs pay to the budget; and gradually opening the capital account, appropriately sequenced with financial sector and exchange rate reforms, to increase the range of available investment opportunities and ease pressure off the real estate market.
Rodlauer said that these reform directions and policy objectives were in line with the authorities’ recent announcements, but that “timely and focused implementation will be crucial for success.”
A tradeoff worth making
The report emphasizes that accelerating the reform process is critical to shift China’s growth path and avoid a sharp correction down the road, but notes this may entail a moderate slowdown in growth as the economy adjusts.
“This is a tradeoff worth making,” said Rodlauer. “It comes with the benefit of more durable, environmentally sustainable, and socially inclusive long-term growth, which will result in substantially higher living standards for China’s population. Moreover, it would deliver favorable spillovers to the rest of the world by helping to foster robust and sustainable global growth,” he added.
