Reforms can no longer be delayed given both the scale and the urgency of the challenges now faced. There can be little doubt that 2013 was a deeply disappointing year for the Chinese economy. While the authorities would no doubt point to GDPs expected growth last year of around 7.7% as evidence of a job well done, growth has come at a high cost with the economys already wild imbalances and addiction to cheap credit intensifying further. First, and foremost, Chinas increasingly stressed and complex financial system remains largely out of control with the pace of new credit creation continuing to expand at a frightening rate. Despite repeated attempts to rein in the so-called shadow banking system, the net new flow of creditTotal Social Financing (TSF)looks on track to register its fifth successive year of growth of
30-35% of GDP. Our estimates imply that the total stock of credit is growing at almost 20% in the final months of 2013. That there has been no decisive cooling in the pace of credit growth is shown by the fact that TSF growth in November was the strongest for that month on record.
Taken at face value, the authorities stepped-up reform rhetoric signals that they recognise that further delay only ensures that the macro trade-offs available deteriorate further. But the willingness to take decisive action still remains unclear however. Actions ultimately speak louder than words: the scale and speed of action in three inter-related areas this year will largely determine whether the authorities reform blue-print is the real deal, or the latest in a long line of false dawns. The first is the
Peoples Bank of China's (PboC) ongoing game of cat-and-mouse with the inter-bank market. Another key lesson of recent years would seem that piecemeal attempts to rein in credit growth via regulatory changes fail. Last years much trumpeted attempt to cool issuance of wealth management products (WMPs) and associated shadow banking rectification has been a notable failure so far with issuance of WMPs accelerating in 2013H2, as shown in the corresponding graph. Only decisively higher rates will choke off still burgeoning demand. There are signs that the PBoC is moving to a tougher love regime, gradually tightening liquidity, ensuring that banks funding costs are on an upward arc and so working to reduce systemic financial risks at least at the margin. But the systems aggregate liquidity needs are now so large that the PBoC is discovering that even the smallest of taps on the monetary brakes are producing wild lurches in interest-rates. Banks increasing use of wealth management products to attract deposits has progressively increased volatility in their deposit bases and so their short-term wholesale financing needs. A safe forecast is that banks short-term funding costs will continue on average to be guided higher by the PBoC this year but that volatility will remain high. And the dubious nature of the credit quality of many WMPs constituent components also means that the risk of bank runs on WMPs, whilst still low, continues to hover in the wings.
Second, and closely related, is the need to stop subsidising banks long term funding costs via capped deposit rates. Most economists agree that this is the corner stone to ensuring that capital becomes more efficiently priced and, in turn, better allocated. Further progress down the road to deposit rate liberalisation is therefore the real key to rebalancing the economy and restraining the increasingly anarchic development of the shadow banking system that both perpetuates undesirably rapid local government borrowing and feeds short-term interest-rate volatility. Uncapping deposit rates will help bring deposit competition among banks out of the shadows, helping reduce increasingly volatile liquidity requirements and boosting the real returns available to depositors. Baby steps continue to be taken by the authorities with negotiable deposit certificates (NDCs) priced off SHIBOR introduced in the interbank marketthe first market-determined deposit rate allowedlate last year. Only available to interbank participants, and at tenors from 3 months to one year, the next critical steps to watch will be the extension of NDCs to corporate and household deposits and also the long-awaited establishment of a deposit-insurance scheme. The latter is a necessary and prudent precursor to full-scale deposit rate liberalisation and the intensified competition that will follow in its train.
Last, and by no means least, is the urgent need for reform of local government finance. Without this, the authorities cannot hope to rein in either the shadow banking system on a sustained basis or bring the real estate sector to heel. Given the soaring liquidity needs identified by the local government audit, choking off the supply of shadow finance to local government financing vehicles (LGFVs) risks imparting a dangerous liquidity shock to the system and further reaccelerating dependence on land sales, or both. Putting local government finance on a sounder footing is also vital to allow effective reform of the hukou system as this will leave local governments with much larger social spending responsibilities. With the helpful tailwind of the new audit office report, rapid progress on the proposed extension of direct local government bond issuance is hopefully forthcoming.
Four inter-related developments have long seemed inevitable for the Chinese economy: a substantially higher cost of capital, reduced investment particularly in real estate, sustained compression in banks net interest margins and a continued slowdown in the pace of sustainable GDP growth. All four necessarily generate losers and create risk. But the longer these developments are delayed, the greater the losses and the larger the risks. 2014 represents a golden opportunity for Chinas leaders to finally take the decisive action needed to ensure medium-term macro-economic stability. But the jury remains out on whether it will be taken. The reported unwillingness to lower 2014s growth target to below 7.5% is a worrying sign that hard decisions may continue to be shirked despite stepped-up reform rhetoric.
The author is Chief Asia Economist, BNP Paribas