China’s financial sector has overly expanded amid its leverage ratio surging high. It is logical for China to redirect capital from idling in the financial sector to real economy. However, does such deviation necessarily lead to a boost to the real economy? This is a complicated issue requires a thorough discussion.


Xunlei Li

May 29th ,2017


Mr. Xunlei Li serevd as the Chief Economist and Deputy General Manager at Haitong Securities Co., Ltd.


Translation by Celine Cai and Ren Zegang


In the past five years, China’s financial sector has overly expanded amid its leverage ratio surging high. Excessive money circulating within the financial sector has resulted in contribution of the Chinese financial sector to the growth of national GDP in excessive of that of Japan, EU and United States. Therefore, it is logical for China to redirect capital from idling in the financial sector to real economy. However, does such deviation necessarily lead to a boost to the real economy? This is a complicated issue requires a thorough discussion.


Return on investment sets proportion between real and virtual


Over the years, money supply in China has risen crazily. Though it is not fully internationalized, the size of the Chinese banking system has become the biggest in the world. Large amount of money is in circulation within the financial institutions.


This situation is closely related to low return on the investment to the real economy. According to the Chinese bureau of statistics, from January to April 2017, the gross profit of the whole manufacture sector is 2278 billion yuan. Although up by 24%, the increase is from a low basis of last year. The return rate is still low given the total capital in the whole manufacture sector is 105 trillion yuan.


The growth of investment in the manufacture sector is only 4.9% from January to April this year indicting the extent for economic upswing is very limited. In the contrast the investment in infrastructures is up by 23%. Without such high investment in infrastructure and real estate, the economic growth would vastly decline.


The investment in infrastructure is mainly supported by government expenditure. For the local governments, developing real estate projects and attracting investment for the setup of regional financial center are the main ways to gain revenue and capital, which is vital in the competition among Chinese local governments for GDP expansion. However such government supported expenditure can not last forever and investment in the real estate industry seems to be unsustainable too as sale of property is going to dwindle in the mid-and-long term.


At the moment, it is a right time for de-leveraging. Since the last half of 2016, there has been a short term upswing in the Chinese economy and that is when de-leverage started.


Monetary policies are contracting. Return rate on bonds has increased. For example, the Ministry of Finance has issued 3 and 7-year national bonds with fixed interest rate of 3.6739% and 3.7250%, higher than the market expectation of 3.64% and 3.67%. In addition, the 7-year bond has greater return rate than that of 10-year.


As a result of the increase in interest rate, the capacity of government to finance its expenditure through issue of bond is significantly reduced. At the same time a bearish mood has made financing through stock market ineffective. All conditions have made financing hard and expensive now.


De-leverage and leverage both are double-edged swords: expansionary monetary policies lead to a reduction in interest rate which promotes enterprises and individuals to leverage and lead to systematic finance risk. In the contrast, de-leverage, drop in money supply and up in interest rate, has the potential of causing an economic downturn.


It is hard to strake a balance between stability of interest rate and financial de-leverage at the same time. Even if it does, we can not really prevent a downturn of the economy. The speed of the Chinese economic expansion has already shifted from high to medium, which indicates that the service industry will grow faster in proportionately to industries in primary and secondary sector. Under such a circumstance, a boost to real economy will be a hard task.


Slowdown induced excessive financial expansion


When everyone is talking about the imbalance between the real and virtual economy, few would wonder why it exists. In fact, the expansion of virtual economy in China is resulted from the desire of maintaining a stable economic growth. In order to support growth, the expansion of money supply has always been a double-digits. Growth rate of investment on fixed assets has never come down. Especially in the infrastructure sector the rate of investment has been continuously around 20%.


In order to keep the economy going, the central bank has been constantly reducing the bank reserve ratio and interest rate since the fourth quarter of 2014. This in combination with deregulation of the financial sector, has resulted in a surge in the proportion of financial sector to GDP in comparison to the real industries. From the beginning of 2016, the central bank lowered the mortgage threshold which has induced an increase of leverage in the housing market. Sales in real estate reached a new high in 2016. Mortgage loans account for more than 60% of all the loans by the four biggest banks in China. Hence, leveraging of the economy has extended to almost every citizen since 2015 and 2016.


Financial support is important both to mass innovation (creation of high-tech startups) and the “belt and road initiative”, which are the key government policies to support the economy moving. However the greater the goal, the more requirement for financial support. The longer the supporting duration, the lower the margin of effectiveness of monetary expansion. That is to say, under the condition of potential economic slowdown, increased money supply has to be made available in order to keep economy going. Given difficulties in promoting real industries, capital is inevitably being channeled into virtual economy. As return on investment in financial institutions and real estate industry is much higher than that of in real industries, it is inevitable that capital will turning away from “real” to “virtual” and cause rise in leverage-level and formation of financial bubble.


Therefore, the expansion of virtual economy is not only due to low return on the investment to manufacture but excessive investment in infrastructure and real estate industry supported by the government. The high leverage can be considered as a cost to a man-made economic growth. As the government is the ultimate sponsor of the financial institutions which are mainly state owned or state controlled, the potential run on banks makes the risks in association with the Chinese financial industry very high.

china investment on infrastructures

De-leveraging, is it really going to be different this time?


Early in 2014, the Central Economic Working Conference has proposed that “from the perspective of formulating solutions to deal with accumulated economic risks, as the economy continues to slow down, all kinds of tacit risks are turning explicit. The overall risk is controllable. However, risks relate to high leverage will last for some more time. We have to resolve the current problems as well as the causes. It is important to suit the remedy to the case and establish a systematic mechanism that can resolve any sort of risk”.


In the first quarter this year, Chinese GDP growth has reached 6.9%. The upswing started from the last quarter in 2016 which makes it such a good time to extensively de-leverage.


The growth of government revenue in the January to April this year is also on the rise thanks to sales of land, profits from state-owned enterprises and improved fiscal revenue compared to that of last year. Added that investment in infrastructure and real estate is also rising which means there would be smaller impact of deleverage on economic growth.


As a result, the majority of commentary believes that the enhanced government financial regulation and deleverage are going to be different this time. The capital bubble is expanding and debt in the whole society is so huge that it has to be solved now. Hence, the regulatory board is forced to prolong and strengthen its position in deleverage. Indeed, the situation now is different from the past.


Even so, we still have to make an objective judgment on the tighter regulation. After all, we have “this time is different” stories every year. And the results are usually not as expected.


We have at least 3 types of mode in regard to reform and economic growth. The first one is reform goes first even at a cost of a hard landing to economy. The second mode is to make stable growth a priority and then propels reform without causing financial crisis. The third is growth only without carrying out any reform. China currently is promoting the second mode.


“Reform under stabilization” has been the theme in the past six years which means a balanced relationship between economic growth, systematic reforms and improved government regulation. During the process of deleveraging, the decision makers have to fully consider the impact of it on economic growth. Meanwhile, the consequences of ageing of population should be fully pondered. In addition, it is necessary to think about whether the measures to prevent financial crisis would lead to the burst of financial bubble.


Under the principle of pursuing a stable growth and precaution of risks, we probably would not expect the regulation on the financial sector to be overly strict. Hence, compared to the past deleverages, there are both difference and similarity this time. It would last longer in duration but be moderate in intensity as the government will prevent the asset price from fluctuating too much.


In this way, we do not have to be too pessimistic about the virtual economy. Use dialectical logic in investment: “what goes up must come down”. Do not get too optimistic about the real economy in the time that China is shifting to a slowed pattern in economic growth.