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Monetary policy and China’s soaring leverage problem

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The headquarters of the People's Bank of China, Beijing, 20 November, 2013 (Photo: Reuters/Jason Lee).

In Brief

China’s leverage ratio — the ratio of debt to assets or equity — is rising at an alarming pace and approaching a historical high. High leverage ratios have in the past caused concern that financial asset bubbles in China might soon burst.

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According to the Bank for International Settlements, although the overall non-financial leverage ratio remains reasonable, the proportion of non-financial corporate borrowing to GDP in China has surged from 99 per cent to 170 per cent since the global financial crisis. Moody’s estimates that even this could be a significant underestimate due to credits given through unrecorded ‘shadow banking’ transactions.

The root cause of the rising leverage ratio is incomplete economic reform, especially the government’s continued protection of state-owned enterprises (SOEs). Disaggregated data confirm that SOEs were the main contributors to rapidly rising leverage ratios in recent years, while the private sector actually showed signs of deleveraging. Firm-level data compiled by China’s National Bureau of Statistics show that SOEs still take 55 per cent of total credits but only contribute 30 per cent of total fixed asset investment.

Bank credits are also much cheaper for SOE borrowers, despite their lower productivity and profitability. The government’s implicit guarantee of SOEs makes them less ‘risky’ but encourages them to spend more — a typical moral hazard problem.

As the lender of last resort, the People’s Bank of China (PBC) is expected to act in a timely way to contain financial risks associated with rising leverage ratios. The PBC has already micro-adjusted their monetary policy stance from prudent with an easing bias last year to prudent with neutral bias this year.

This may have been out of concern for growing financial risks. But so far there is not a widely accepted rule as to how central banks should respond to financial instability. Some suggest that central banks should take into account financial conditions when making monetary policy, while others argue that central banks should focus on conventional policy objectives such as price stability.

I recently completed a study examining the PBC’s response to financial stability indicators by asking three specific questions. First, would a tightening monetary policy decrease leverage? Second, how effective would it be? And third, what are the potential costs of a monetary policy response to financial risks?

In theory, tightening monetary policy increases firms’ cost of borrowing and would directly decelerate credit growth. But the leverage ratio can also be affected by the indirect slowdown of asset accumulation due to inhibiting economic growth. The two forces offset each other and the net effect varies with economies and periods. Higher potential economic growth with great demand for liquidity makes the latter effect dominant. Yet a tightening monetary policy may inhibit asset growth more than that of liability and actually increase leverage.

The presence of SOEs further complicates the question. Under a tightening monetary policy environment, banks charge a higher lending rate and become more cautious when granting loans. But SOEs are less sensitive to borrowing costs than other firms and are often considered less risky borrowers with implicit government guarantees. This makes SOEs more favourable to financial institutions. The decrease of loans to SOEs would therefore be smaller than to non-SOEs, and in extreme conditions loans to SOEs, which are less productive, would actually increase and overall leverage would rise.

But even if tightening monetary policy has the ability to tame surging leverage, could it be effectively implemented? Unlike traditional monetary policy targets, financial variables such as leverage can be very volatile and subject to not only real shocks but also more unpredictable financial shocks like market sentiments and drastic political changes.

This implies that only a significant change of monetary policy can have a real impact on financial variables. And central banks would need accurate forecasts of the sources and sizes of unpredictable external financial shocks.

But what is the cost? Monetary policy is a blunt tool, and has broad impacts on the economy. When its goal is diverted to containing financial risks, there is less focus on conventional inflation and unemployment targets. In China, inflation and the leverage ratio have been in general moving in opposite directions. A single monetary policy action aimed at lowering leverage will probably push up inflation if this pattern continues.

Financial risks can be harmful and central banks should move with extreme caution in responding to them. For China, monetary policy could help with lowering leverage. But is not the ideal tool to deal with it.

The effects of monetary policy in China are blurred due to economic frictions, including SOE-related distortions. Simply drawing on experiences from advanced economies may lead to unintended results. And with monetary policy reform ongoing, China’s financial markets are still underdeveloped, the markets are highly volatile and investors tend to overreact. Frequent monetary policy adjustments in response to financial instability would only enhance market volatility.

Trying to maintain both inflation and financial stability would divert the limited power of monetary policy and complicate the evaluation of central bank performance.

To address the surging leverage issue, the root cause of rising leverage should be addressed through reform. China should adopt and strictly implement macro- and micro-prudential measures to prevent systemic risks. Instead of directly targeting leverage, the PBC should take the spillover effects to financial markets into consideration of all their decisions and closely cooperate with financial regulators. Further financial liberalisation and the removal of special protection for SOEs are also essential.

Ran Li is a PhD candidate at the National School of Development, Peking University.

3 responses to “Monetary policy and China’s soaring leverage problem”

  1. While your work in that survey and in your pursuit is interesting and possibly important, one has take a broad and creative approach to what monetary tools can and can’t do. A useful lesson is what the FED did or has done in the aftermath of the Global Financial Crisis (particularly the financial crisis in the US following its subprime bursts.
    You stated that: “Trying to maintain both inflation and financial stability would divert the limited power of monetary policy and complicate the evaluation of central bank performance.”
    Please have a look at what the FED did, often dubbed as the so called an unconventional approach/method, and you may come to a very different conclusion.
    One should not simply take the conventional view of monetary policies and be limited by that. One has to think creatively in dealing with the often complex reality.
    I think China has done quite a bit in the way of creative approaches in terms of monetary policies in dealing with banking reserve ratios and non-first home housing lending/loans.
    You also argued that “To address the surging leverage issue, the root cause of rising leverage should be addressed through reform. China should adopt and strictly implement macro- and micro-prudential measures to prevent systemic risks. Instead of directly targeting leverage, the PBC should take the spillover effects to financial markets into consideration of all their decisions and closely cooperate with financial regulators. Further financial liberalisation and the removal of special protection for SOEs are also essential.”
    Unless your reforms include creative approaches such as what the FED and the Chinese authorities have done, your advocate may be really too conventional and lack of some common sense. One should not be simply following a ‘textbook’ approach because that may be dogmatic.

    • I fully agree with Lintong. I live in the US and have seen the FED reign in inflation successfully. It ‘manages’ our nation’s monetary rates which may benefit some at one time and others at another time. Our interest rates are so low right now, that an example is how housing has benefited. It would be silly to purchase a CD right now, and treasury notes figure only to balance more active investing in business. It works.
      I do see that SOE’s need to slowly (but not TOO slowly disappear completely. But, in doing so, they must be replaced by sound NON-state owned businesses.
      China needs to get out of business’s way to continue progress… at this time.

      • Thank you CCROGERS. I agree that China needs to address the issues and problems with its SOEs. Although ownership can be an issue, the efficiency of SOEs and their disproportionate use of resources particularly bank credit reflect very poorly on them. I hope that China can find a way to address them using economic reforms, or it will be forced to privatise them or at least substantial of them.

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