Swedbank Asia Analysis

No. 14  21 November 2012

China’s strained economy – the new political leaders should focus on reforms rather than stimulus 
After a massive stimulus through the banks in 2008-2010, China is struggling with overcapacity and bad loans. The situation in the financial sector seems worse than statistics indicate. Many lenders are rolling over loans and hoping that the Chinese central bank again opens the spigot. In recent years China has borrowed from the future, and the question is whether it will choose the easy route with new infrastructure investment or whether it will accept slower growth driven more by household consumption. If the investment fervor continues, there will be a hard landing down the road. The economic turnaround now being talked about is based on meager gains and hopes of a new stimulus. A bottom may have been reached, but the recovery will be cautious and vulnerable. We are revising our GDP growth forecast downward from 7.9 percent to 7.7 percent this year and still expect it to stay below 8 percent in 2013 and 2014, in line with China’s goal of 7–7.5 percent in the coming decade. The new political leadership is facing major challenges: corruption, a rebalancing of China's growth model from investments to consumption, a shrinking workforce and concerns about a middle income trap in the absence of innovation. Energy and the environment, urbanization and demographics, and international relations (including maritime conflicts) are also challenging the party and the military. China’s leaders should show some backbone and reform rather than resort to more stimulus. The question is whether the new leaders have enough interest in reforming or whether special interests will be allowed to maintain control and protect the status quo. This applies especially to the continued deregulation of the financial sector. This report reviews why it is important and what could prevent further development. The global economy would benefit if Chinese growth were lower and more sustainable and if financial deregulation were fully implemented. Countries and companies that are stuck in the old business model will face increasing difficulty, while others could benefit from increased demand from China’s consumers as they place greater value on quality and other long-term considerations.
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Contents China’s critical questions China’s economic outlook – just hopes? Challenges facing the new political leadership Deregulation of the financial sector: Why, why not and how? Consequences for the global economy

Economic Research Department, Swedbank AB (publ), SE-105 34 Stockholm, tel +46 (0)8-5859 7740 e-mail: ek.sekr@swedbank.com Internet: www.swedbank.com Responsible publisher: Cecilia Hermansson +46 (0)8-5859 7720. Magnus Alvesson +46 (0)8-5859 3341, Jörgen Kennemar +46 (0)8-5859 7730 ISSN 1103-4897

1. China’s critical questions
It is easy to presume that China’s economic position is strong and that the outlook is good, since GDP growth is relatively high (despite falling from 9-10 percent to 7-8 percent in the last year). It also has a low debt level (reportedly about 30 percent of GDP) and huge currency reserves (USD 3 300 billion). However, the situation is probably much worse than most analysts in the West realize. First of all, it can be difficult to interpret Chinese data, if they are even available. The economy has probably grown more weakly or shrunk of late, and after the massive stimulus in 2008-2010 bad loans are probably closer to 15-20 percent of outstanding bank loans than the 1 percent reported. Now property companies, local governments and state-owned enterprises have to be rescued and their debts assumed. Companies aren’t getting paid and lenders are rolling over credits, which hides the bad loans for a while longer. In the wake of strong credit growth, the shadow banking system has grown. In the absence of transparency, there is a risk of Ponzi schemes. Secondly, it is common to say that China, with its low inflation, can now pump new liquidity into the system to reinvigorate demand. The Chinese central bank will not repeat the mistakes from 2008-2010, which led to overcapacity and financial instability. The problem isn’t consumer prices. It’s the debt buildup and bad loans owing to the declining quality of the lending and underlying assets. Thirdly, China borrowed from the future and built too much capacity. The construction industry is reporting that some production has increased so much that nothing more has to be built for the next 7-8 years to keep pace with demand. This will restrict growth in coming years. Fourthly, China's economy has been painted into a corner. When loans are rolled over, resources aren't available for new investment. By starting the printing presses and pumping in new liquidity, investment will increase more and more, which is a must to generate the same growth as before. At the same time China’s leadership had planned to rebalance to lower, more sustainable and greener growth driven more by consumption than investment. A new recession in the rest of the world may force China to return to its proven recipe. Infrastructure investments are already in the pipeline – not as large as in 2008-2009, but still just over 2 percent of GDP in the next four-year period. Instead of stimulating and driving the economy through more investment, China needs reforms. This report focuses on the financial sector’s deregulation as a key to a better functioning economy. It would reduce corruption and the influence of state-owned enterprises and would facilitate a rebalancing in favor of household-driven growth. Other important reforms involve fiscal policy (taxes, social insurance), the hukou system for migrant workers and corruption fighting. Challenges also include demographics, urbanization and relations with the rest of the world, especially as conflicts with Asian neighbors grow. A huge agenda for the new political leadership! Lies, damned lies, and statistics!

Lower inflation is no reason to open the spigots

China has borrowed from its future

China has to find the courage not to take the easy way out: new investments

Less stimulus, more reforms!

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2. China’s economic outlook – just hopes?
Still no clear trend in economic data In 2012 the Chinese economy slowed significantly, probably more than statistics indicate. The reasons for the slowdown can be found in weaker global demand, which has impacted China’s export outlook, but primarily in its own austerity policies, which followed the major stimulus in connection with the global financial crisis and recession in 2008-2009. Credit growth peaked at 30 percent in November 2009 and contributed to an overheating, which authorities today regret and want to avoid repeating.
Inflation and monetary policy

External and internal reasons for China’s slowdown

When inflation rose significantly (at most to 6.5 percent in July 2011) after authorities stimulated demand through state-owned banks’ lending, it launched a period of higher reserve requirements and lending rates in 2010-2011, which slowed credit growth. About a year ago the central bank began to loosen monetary policy by cutting cash requirements, but by then the effects on land and property sales and prices were already clearly negative, and worries about an economic hard landing had increased. In China’s situation, it would be enough for GDP growth to fall below 6-7 percent to cause economic and political instability. A hard landing can be generated by tightening economic policy during an overheating, but can also happen if capacity in the economy continues to expand, the financial and real estate sectors become more unstable, and demand fails to keep pace. The first reason is the main concern at this point, but in a few years the bigger risk is that overinvestment will lead to excessive capacity, which could later create a financial and real economic hard landing. The question domestic and foreign experts are now asking is whether the Chinese economy has hit bottom and a turnaround has begun? Monetary policy has been eased to avoid a hard landing

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It is difficult to see a clear turnaround in economy data, but the weakest sector data were reported in August and September, while October showed signs of slight improvement. This was probably a reflection of hopes that looser monetary policy and more expansive fiscal policy through infrastructure investment and tax rebates will stimulate demand. Around RMB 1 trillion, or just over 2 percent of GDP, will be invested in infrastructure during a four-year period. Some data have been used as “proof” that the economy is recovering, including stronger exports, higher growth in industrial production and slightly stronger retail sales. Leading indicators published by the Conference Board (see below) also show a turnaround. Note that the gains to date are marginal and don't indicate a clear reversal of the trend. In October export growth rose to 11.6 percent, compared with just over 1 percent in July of this year. The trend is anything but clear, however, since exports rose by as much as 15 percent in May, and for the most part has fluctuated throughout the year. Import growth was unchanged in October, due to which the trade surplus thus far this year has exceeded the average for 2011. China’s exports are being driven by demand from other emerging markets and the US, while exports to Europe have fallen.
Change in exports and imports (current prices), and in GDP (fixed prices)

A bottom may have been reached, but much of the upswing is based on hopes that the stimulus will have an impact

No clear trend in export growth, but October showed improvement

Although GDP growth has continued to fall at an annual rate, from 9.1 percent in the third quarter of 2011 to 7.4 percent in the same quarter of 2012, the quarterly rate has risen slightly, from 1.5 percent at the start of the year to 2.0 percent in the second quarter and 2.2 percent in the third quarter. Public investment (initiated at a central rather than local level) is driving growth. Local authorities are highly indebted and lack financing for major investments, a situation exacerbated by a 16.5% decline in land sales so far this year, which also makes it hard for them to service the debt. Instead the National Development and Reform Commission (NDRC) accelerated the rate of investment in May. At the same time the government chose to give tax rebates and subsidize demand for consumer goods.
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At a quarterly rate GDP growth hit bottom in early 2012

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Growth in industrial production has also begun to rise (to 9.2 percent in October against 8.9 percent in August), but the upswing is marginal and the purchasing managers index hasn’t shown a clear trend. The purchasing managers index from the National Bureau of Statistics (NBS), which mainly measures industrial conditions for large stateowned enterprises, is fairly good at identifying turning points. HSBC is more focused on small and medium-sized businesses and provides a better indication of the current situation. In reality, the slowdown seems to have been greater than the purchasing managers index indicated. An upswing in industrial production is consistent with the index, even if it is below or near a reading of 50, which suggests slightly higher production growth. Note that the annual rate isn’t always a good indicator. Measured at a monthly rate growth has been weak or negative. Moreover, unchanged or slightly rising electricity production suggests weaker manufacturing conditions. The outlook is for conditions to improve slightly as a result of the stimulus, and eventually stronger external demand as well.
Change in industrial production and purchasing managers index (from HSBC and NBS)

Slight upturn in industrial production growth

While private investment is falling, private consumption continues to rise. Retail sales gained 14.5 percent in current prices in October, compared with 13.1 percent in July. In October auto sales also rose (5 percent), after having slumped in September for the first time in a year (apart from Chinese New Year). Household confidence according to the Conference Board doesn’t give a clear signal that stronger confidence would support higher consumption. Leading indicators as a whole are rising, but the increase is too marginal to be interpreted as proof of a turnaround.

Household consumption is rising, but with no clear trend in future confidence

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Change (%) in retail sales, in current prices, and index of leading indicators (total and household confidence)

... but the coming upswing should be cautious and fragile In our latest forecast from October we predicted GDP growth of 7.9 percent this year, and that it would slow to 7.8 in 2013 and 7.6 percent in 2014. Now it seems difficult to reach 7.9 percent this year, which would require growth of 8.5 percent in the fourth quarter. Instead, it is reasonable to expect a slight increase from the current rate of 7.4 percent to 7.6 percent, with the annual number reaching 7.7 percent. What's in the cards for 2013 and 2014? Several factors suggest that GDP growth will stay below 8 percent:  The political goal is GDP growth of 7.5 percent, so it is likely that the final number will be close to that. This goal includes greener, more sustainable growth, at the same time that the target is to double GDP (and GDP per capita) by 2020 (about 7 percent growth), which wouldn't help the rebalancing to consumption-driven growth. Central political authorities don't want to repeat the mistakes that led to an overheated real estate market and put local authorities and stability in jeopardy. Infrastructure investments of 2 percent of GDP during a four-year period won't stimulate the economy enough to return to 9-10 percent growth. Even if the US also continues to slowly recover and emerging market demand is relatively good, China faces a deteriorating outlook due to its other key export market, Europe, which is wrestling with major economic and structural problems. Our GDP forecast for 2012 has to be revised downward

We therefore expect GDP growth to rise from 7.7 percent this year to 7.9 percent next year, but that the financial sector’s imbalances will gradually impede growth prospects, limiting GDP growth in 2014 to 7.5 percent.

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3. Challenges facing the new political leadership
The party has appointed China’s new leaders1 After the Communist Party’s 18th Congress concluded in Beijing, we know who will take over control of the country. Former President Hu Jintao and Prime Minister Wen Jiabao have handed the baton to Xi Jinping and Li Keqiang. This particular power shift had been expected for years, though it was less clear who the other members of the Politburo's Standing Committee would be. We now know that the Standing Committee has been trimmed from nine members to seven and that five new members had to be appointed for age reasons. We also know that Xi Jinping will not have to wait two years to take over responsibility for the military, as his predecessor had to do when Jiang Zemin (and even Deng Xiaoping) retained the position after stepping down as president. Consequently Xi has consolidated his power. However, both Jiang Zemin (86) and Hu Jintao (69) are still alive and will influence Xi’s policies from behind the scenes. Of the two, Jiang would appear to be the stronger. The presidency is probably less significant today than when Mao Zedong, Deng Xiaoping and even Jiang Zemin held it. During Hu Jintao’s time it became something of a “chairmanship,” and the eight or so fractions/families with political influence were concerned with finding a candidate who represented compromise, moderation and predictability. The latter was hardly a description of “crown prince” and former party boss in Chongqing Bo Xilai, who was expelled from the National People’s Congress and Politburo after having made his mark as a hard-driving populist who flirted with the West. Whether his dismissal was the result of his (and his wife’s) criminal actions and/or his political opponents’ recriminations is still unclear. That this power struggle has been fought out in the open is something new to China and is probably due in part to social media and the growing difficulty in reconciling the various factions within the party, all of whom have special interests to protect. What do we know about the seven members of the Politburo’s powerful Standing Committee? 1. Xi Jinping Xi (59) has already been named the party’s new secretary general and chairman of the party’s Central Military Commission, but will have to wait until the parliament’s annual meeting in March to be sworn in as president. He is considered a cautious reformist.
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Better decisions with fewer members of the Standing Committee?

An unusually eventful lead-up to the Party Congress

Xi consolidates power

The party consists of around 80 million members and in practice does not choose its leaders. The Party Congress has 2,270 delegates and selects a central committee comprised of 200 members and 150 alternates. This is the committee that elects the Politburo, comprised of around 25 members (24 now that Bo Xilai has been forced to step down). It is unclear how the Standing Committee – the real power in China – is chosen. It is probably done more informally. The government and parliament are part of a parallel power structure, but the Standing Committee ranks above it.

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Together with Li, he is the only member to have previously sat on the Standing Committee and, like a number of others, is allied with Jiang Zemin. As a princeling, or heir to a former senior leader (Xi Zhongxun was purged by Mao but later rehabilitated), Xi could attain a stronger position in the party than his predecessor Hu. His ascent within the party began in an impoverished agricultural region in Shaanxi province, after which he became governor of Fujian province in 1999 and party boss in eastern Zhejiang province in 2002. In 2007 Xi was given the opportunity to take over in Shanghai when the man he replaced was convicted of corruption, and later the same year was elected to the Politburo’s Standing Committee. As a leader, he is seen as more charismatic and open than his predecessor. 2. Li Keqiang In March Li Keqiang (57) is expected to take over as Prime Minister. He is also considered a cautious reformist and is allied with Hu Jintao, who would have preferred seeing Li as president. Both rose through the Communist Youth League, in contrast with the princelings. Li is well-educated in both law and economics (where he received a PhD in 1982), so he presumably has a better understanding of the role of the market, and as Prime Minister will be responsible for the economy and reforms. As governor of Henan province, he waged a hard-line campaign against activists protesting an HIV scandal before being named party chief in the industrial province Liaoning in 2004 and later a member of the Politburo’s Standing Committee in 2007. 3. Zhang Dejiang It was Zhang Dejiang (65) who took over as party chief in Chongqing when Bo Xilai lost the party’s confidence – due to his close connection with Jiang Zemin. He earned his stripes in North Korea and is considered conservative. He will ascend to the powerful position of chairman of the Standing Committee of the National People’s Congress. Besides the Bo Xilai affair, China saw another corruption scandal unfold in 2012 when railway minister Liu Zhijun was forced to step down, which also hurt Zhang, though he retained his position. His career was also blemished by his handling of the SARS epidemic, but on the other hand he managed to achieve high growth when he was party chief in Guangdong province. 4. Yu Zhengsheng Yu Zhengsheng (67) is party chief in Shanghai and is considered a cautious reformist. He will be appointed chairman of the Chinese People’s Political Consultative Conference. Yu has close ties to Deng Xiaoping’s son Deng Pufang, which saved him from disgrace when his brother defected to the US. He has been a member of the Politburo since 2002, but hadn’t succeeded in rising to the Standing Committee until now. He considers the Cultural Revolution a personal mistake on Mao’s part. 5. Liu Yunshan Yu feels that the Cultural Revolution was a personal mistake on Mao’s part Zhang will become chairman of the National People’s Congress Li has shown interest in the reform agenda

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Liu Yunshan (65) will take over as chief of propaganda. He has experience as a reporter for Xinhua in Inner Mongolia. Liu has served as director of the propaganda department since 2002 and has tried to control the Internet (which today has an estimated 500 million users, though some may have more than one account). He has been a member of the Politburo since 2002. Liu’s political background was in the youth movement, which explains his close contacts with Hu Jintao. 6. Wang Qishan As one of four Vice Premiers, Wang (64) is the most experienced politician to be appointed. He previously served as mayor of Beijing in 2004-2008 and governor of the China Construction Bank in 1994-97. Wang is considered a reformist, especially in the financial sector, and has managed international trade relations, including with the US. He is a princeling and son-in-law of a former member of the Standing Committee, Yao Yilin. Wang will now assume responsibility for fighting corruption, one of the biggest challenges facing the party. 7. Zhang Gaoli While Zhang Gaoli (66) has Jiang Zemin’s confidence, he also has Hu Jintao’s. As party chief in the northern port city of Tianjin he has welcomed foreign direct investment and was previously responsible for reforms in expansive Shenzhen. Zhang studied economics and is regarded as a financial reformist. It doesn’t appear that he will have a specific portfolio, but could become one of the highest ranking Vice Premiers. What does this power shift mean in practice? There are signs of cautious reform within the new Standing Committee, but at the same time a conservative streak is evident as well. Because of the Bo Xilai scandal, cautiousness may have increased, and compromise and moderation carry greater weight. It wouldn’t be worth risking new scandals by selecting a more radical person. Five of seven members will be replaced at the next party congress for age reasons. Only Xi and Li will serve another five-year mandate. The 12th development plan, which took effect in 2011 and extends through 2015, already spells out the political goals. It will take at least a year or two before the new members make any significant changes, if at all. While most experts have an idea of what is needed for China’s further development, there are big differences exactly how it will be done and when. Special interests that benefit from state-owned enterprises will certainly want to put a stop to further liberalization, where the party would also lose control. In the political arena, Hu Jintao’s speech appears to be a sign of the current direction. Democratization can be seen within the party, but not the Western model.

Liu will become propaganda chief in a world of social media

Wang will now fight corruption

Zhang has experience with financial reforms

The 12thdevelopment plan remains firm

Special interests could stop the reform work

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Politicians, especially the future president, will be able to express themselves more freely, skip the jargon and demonstrate more charisma. But while the way of communicating and leadership style may change, it doesn’t mean that the political substance will. Important challenges face the new political leadership. Will they manage to address the problems? Though Hu Jintao and Wen Jiabao were able to avoid criticism when they oversaw the previous market reforms – during a decade when China’s GDP grew by a factor of 2.7 times in fixed prices (just over four times in current prices) and currency reserves rose from nearly SEK 300 billion to SEK 3 300 billion – similarly cautious reforms could create an economic, social and political collapse in the coming decade. China’s politicians cannot risk future development by resting on their laurels.
China’s GDP development in fixed prices and growth rate (%)

Hu and Wen have had it too easy…

The Chinese growth model is losing momentum and the country could face a “middle income trap” if innovation fails to raise valueadded and the standard of living. Slower growth globally, at the same time that Chinese export and investment gains aren’t repeated and the workforce peaks before starting to fall within a five-year period, will create challenges. Significantly slower growth would lead to unemployment and potentially to social and political unrest. More consumption-led (and environmentally sustainable) growth would be lower than the nearly 10 percent annual average we have seen since the early 1980’s. In fact, consumption has fallen during the decade despite the goal of rebalancing growth. The 200 million or so migrant workers have to save more than other urban residents, since they have less access to social security. Consumption could potentially grow if faster reforms were made to the hukou system, which regulates urban populations.

… but the country is at risk of a “middle income trap”

Reforming hukou would benefit the country socially and economically

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Various demand components as a share of GDP

In his address at the Party Congress, outgoing President Hu Jintao said that the target is to double China’s GDP and GDP per capita within a ten-year period. If the environment takes a backseat to the economy, that growth won’t be sustainable. A growing, well-educated urban middle class won’t begrudge others’ success, as long as it is done without corruption and abuse of natural resources. But when executives become rich by poisoning milk and local politicians by stealing and selling land, cynicism spreads. At the same time income gaps, which are already sizable, have increased. The number of demonstrations was estimated at 180 000 two years ago, compared with 40 000 ten years ago. The public’s anger is also noticeable on Weibo (Chinese’s Twitter) and other social media. Prime Minister Li Keqiang was one of the men behind the report “China 2030 – Building a Modern, Harmonious, and Creative HighIncome Society,” which was prepared jointly by the World Bank and China’s Development Research Center of the State Council in November 2010 - September 2011. The report describes and analyzes in detail the challenges for China’s development in the next 20 years: 1. Implement structural reforms that strengthen the transition to a market economy 2. Accelerate the pace of innovation and an open innovation system 3. Utilize opportunities to create “green development” 4. Expand opportunities and social services for all people 5. Strengthen the fiscal system, not least at the local level 6. Seek mutually beneficial relations with the rest of the world.

Corruption has led to cynicism and social unrest

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These six priority reforms have goals formulated for both the short and long term. Now strategies are required for how and when to implement them. China isn’t yet a market economy on the production side. Markets must be given more leeway to set the price of production factors such as land and capital. Accepting this will force the party to relinquish control and reduce opportunities for corruption. State-owned enterprises will be the biggest losers, as will many of the politicians closely allied with them who personally profit. Production by state-owned enterprises has grown and accounts for between one third and half of China’s GDP, but they shrunk significantly in number in the 1990’s. Lending was expanded through the state-owned banks in connection with the financial crisis in 20082009, allowing state-owned enterprises to grow in size and importance both in China and abroad. Now they are instead putting a brake on China’s economic future and generating a smaller share of jobs. Because smaller private companies don’t have access to capital, it isn’t being correctly allocated and the country is not growing as fast as it could be. The International Monetary Fund has estimated that if the state monopoly were opened to competition, the total factor productivity in China would rise and per capita income could increase by a factor of 10 in the long term. Below we show why deregulation of the financial sector would help in the reform of state-owned enterprises and why the Chinese economy as a whole would benefit from successful financial reform. China may be a market economy on the demand side, but not in terms of production State-owned enterprises must be reformed and decline in importance

4. Deregulation of the financial sector: Why, why not and how?
There are many parts to financial deregulation, and China has been deregulating its financial markets for decades, but slowly and partially. At the same time there are signs of accelerated reforms. Many politicians understand how important financial reform would be, but there is a lack of consensus about the order in which the reforms should be implemented and how quickly. The uncertainty stems from how rarely other countries have succeeded in deregulating without creating financial instability and bubbles, but also whether it is worth it for the party to give up control over a production factor as important as the price of money. It is often said that China’s situation would have been significantly worse today if it hadn’t kept control over the financial sector during the global financial crisis in 2008-2009. China now has to make progress in a number of areas: loosening its exchange rate, liberalizing the fixed income market, reforming the bond market, strengthening the domestic banking sector, deregulating the capital account, and developing financial and commodity-related derivative trading. Additional reforms are needed to improve the functioning of the economy: fiscal reform (mainly tax-related but also in terms of social insurance), changes to the hukou system for migrant workers, and giving opportunities to private actors to invest in markets that are currently controlled by monopolies. Risky to deregulate the financial sector – but riskier not to

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Below we list ten reasons why China should continue its financial reforms. This is an important key to correcting the imbalances and meeting challenges in several areas. Studies2 show that financial deregulation produces higher GDP per capita, lower inflation and larger capital flows, but that it also increases the risk of financial instability by encouraging higher returns on capital and lower capital adequacy requirements for banks. Different countries are on different levels, however, and face different conditions. Financial reform in China would: 1. Transform China into a market economy on the production side by letting the market set the price of money and increasing competition for financing domestically and with the foreign market. 2. Improve capital allocation, which today is skewed and is impeding growth in certain sectors at the same time that growth is exaggerated in others. 3. Facilitate the rebalancing from export-investment-led growth to consumption-led growth. 4. Reduce debt problems among local governments, in part by shifting from bank financing to capital markets and by deregulating the fixed income market. 5. Change the role of banks so that they provide less financing for state-owned enterprises and local governments and more to small and medium-sized companies and households. 6. Reduce or eliminate the repression of savers by setting market-based interest rates, while at the same time reducing excess lending. 7. Improve opportunities for the Chinese to invest abroad and foreigners to invest in China by deregulating the capital account. 8. Reduce opportunities for corruption. 9. Reduce the discrepancy between the size of China’s economy and China’s importance in the global financial markets. 10. Reduce or eliminate the global economy’s savings imbalances. What would a perfectly executed financial reform look like, and what can China learn from other countries’ mistakes? China has to strengthen its domestic banking sector to continue to open up to foreign competition and capital flows. In addition, fixed income markets have to be deregulated and bond markets developed. Only then should exchange rates be made fully

The rebalancing to consumption will be hard without reforming the financial sector

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IMF Working Paper 12/275: Effects on Capital Flow Liberalizatoin – What is the Evidence from Recent Experiences of Emerging Market Economies?

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convertible. Lastly, there are opportunities to deregulate the capital account. China can learn from other countries’ mistakes mainly by studying the sequence in which they deregulated their financial markets. In Sweden we saw regulated rate setting (a low interest rate policy that occasionally produced negative real rates) and quantitative regulation of commercial lending until the so-called November Revolution in 1985, when the credit market was deregulated. This led to considerable credit growth. With a fixed exchange rate and liberalized capital account, capital outflows increased as Swedish finance and real estate companies invested in property abroad. An internal real estate and financial bubble built up as well. There was overheating with high inflation, and the underlying fiscal weakness was hidden by high tax receipts produced from debt-financed growth. The “tax reform of the century” adopted in 1990-91, together with considerably lower inflation, contributed to a significant rise in real after-tax interest rates. Debt-financed investment was no longer encouraged, and instead the Swedes became more willing to save. This real interest rate shock, along with the recession and German reunification, which resulted in higher interest rates, as well as speculation about the krona, battered asset values, and the bubble burst. Financial crises in other countries illustrate the difficulty in combining capital mobility with fixed (but adjustable) exchange rates. Financial deregulation often leads to a rise in asset prices, investments and consumption, at the same time that savings decline. This is followed by a shock of sorts where capital flows reverse course and the credit expansion comes to an end, bursting the bubble. Officials usually try to defend against currency speculation with higher interest rates before having to give up and let the currency fluctuate freely.
Fixed Exchange rate

Sweden is a good example of how not to deregulate the financial sector

Independent Monetary Policy

Free capital capital movement
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The Mundell-Flemming model shows that no single country can achieve the following three policy goals at the same time: a fixed exchange rate, unrestricted capital mobility and an independent domestic monetary policy, but that a combination of two goals is fully possible. China has to avoid this macroeconomy trilemma by ultimately finding the “right” combination of goals to suit its particular needs. Sweden, just like the US, Canada, Australia and the UK, has a flexible exchange rate, unrestricted capital mobility and an independent monetary policy. Denmark has a fixed exchange rate and capital mobility, but no independent monetary policy. The euro zone has a currency union, but the euro otherwise fluctuates just like

China has to avoid the trilemma – and is now working on all three parts

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the dollar and pound, and thus has unrestricted capital mobility and an independent monetary policy through the ECB. China is working on all three parts, and as a major economy should move toward the Anglo-Saxon (and euro zone) solution. How far has China come with deregulation? What are the obstacles? What type of results can be expected in the coming decade? 1. Interest rate deregulation In the current system, China’s central bank (PBoC) sets a ceiling for savings rates and a floor for lending rates. This generates a high interest rate margin, which produces good profits for (state-owned) banks. The return savers receive is usually less than inflation, which means they are paying the bank to let them borrow their money. Interest rate deregulation would benefit the bond markets as well, since the one-year savings rate is used to price bonds. It would also be easier to remove capital controls and internationalize the currency. Deregulation is mentioned in the 12th Development Plan, and its importance has been stressed by outgoing Central Bank Governor Zhou Xiaochuan. He believes that China’s commercial banks can now manage on their own and that they have to sell other financial services to maintain their market shares, that they have become better at pricing rates and managing risk, and that the Shanghai Interbank Offered Rate (Shibor) has now been established as a benchmark for pricing financial products. Many problems remain, since it takes time to develop financial skills, Shibor says less about rates with maturities longer than three months, and there is no benchmark yield curve, which makes it harder for the financial market to project short-term trends and inflation.
Bank lending and deposit rates as well as interest rate margin

Interest rate deregulation is required to eliminate “savers’ repression”

Interbank rates and interest rates tied to foreign currencies have been deregulated. The hard part now is to follow up by deregulating 29 other rates set by PBoC. On the positive side, banks can now offer 20 percent discounts on lending rates, compared with 10 percent before. For the first time they can now also offer savings rates that are 10 percent above the benchmark. About 70 percent of total bank loans

An important step is to let the lending and deposit be priced under and over the benchmark

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have been granted at rates higher than the benchmark, compared with about 40 percent in 2008-2011. Special interests that benefit from high interest rate margins – both big banks, which get 70-80 percent of their profit from net interest income, and state-owned enterprises, which have had access to cheap financing – want to prevent this from happening. 2. Bond market development In China, banks are primarily responsible for financing, while the bond and equity markets play a secondary role. This trend was strengthened by the huge stimulus packages in 2009-2010, when bank lending rose as a share of GDP from 97 percent in 2008 to 120 percent in 2010. In the wake of the stimulus, bad loans are increasing, especially for local governments. Numbers aren't available, since most loans are rolled over when there isn’t enough liquidity. The difficulty for local governments is that the capital may have been allocated incorrectly to projects which may not be viable and that it will take time before there is a return on long-term infrastructure projects. With different maturities on savings and lending as well as insufficient tax financing of local government budgets, bank financing really isn't the right way to go. It would be better if local governments were allowed to issue their own bonds. According to the China Development and Research Foundation, at least RMB 100 000 in urban infrastructure investment is required for every new person who moves to China’s cities from the country. It is estimated that around 15-20 million people migrate to cities every year, which translates into an annual investment need of RMB 2-3 trillion during the next decade. Loan costs would be lower and risk diversification better if the bond market were allowed to develop. China represents about 10 percent of the global economy, but its bond market accounts for only 5 percent. That makes it smaller than half of lending from banks. Its market capital constitutes 45 percent of China’s GDP. Trading is mainly limited to government bonds (Ministry of Finance) and bonds issued by state banks, the central bank and large (state-owned) enterprises. Whenever possible, local governments issue with the help of the Ministry of Finance. What are needed are better opportunities for small and medium-sized companies to obtain financing in the bond market. Local government debt represents 23 percent of GDP, and that's according to very conservative estimates. The real number is probably much higher. The stimulus that came through the banks and flowed to local governments will come back to the central level when it is forced to take over the bad loans. It could just as well have been a fiscal stimulus that wound up on the central debt account from the beginning. In addition to bank loans, there are so-called LGFV bonds. After a decline in 2010, the latter rose by 160 percent during the first half of this year. The risk of default is considered high. The bond market could easily double within a five-year period Bad loans by local governments are increasing, but thus far they have been hidden by rolling them over

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Cities and local governments will be allowed to begin issuing bonds on a larger scale. At present pilot projects are under way in the cities of Shanghai and Shenzhen, as well as the provinces of Guangdong and Zhejiang. They will spread throughout the rest of the country. This means that more loans will be taken up and that it will become a way to resolve the liquidity problem at the same time that a more long-term financing solution is put in place. Note that if the capital is allocated to projects that are not viable and only lead to overcapacity, the problems will persist and could even worsen. The biggest obstacle to strengthening China’s bond market is the multitude of regulators and supervisors and that the market is fragmented. 3. Exchange rate reform Making the Chinese renminbi, or RMB, a global currency was a priority during the financial crisis, when the value of the US dollar fell and the Federal Reserve introduced quantitative easing, which created the risk of higher inflation and an erosion of the dollar. Since China had built up USD 3 300 billion in currency reserves, it had an interest in making RMB fully convertible. Back in 2005 China decided to introduce a “managed float,” i.e., an exchange rate regime controlled by the central bank. Later, in 2007, bonds were listed in RMB on the Hong Kong Stock Exchange. A year later the central bank added a department for exchange rate policy, and in late 2008 China began, as a result of the financial crisis, to agree to swap contracts with foreign central banks (Russia, South Korea, etc.). In the summer of 2009 a pilot project was launched to use RMB for trade settlements, and in 2011 foreign direct investment (FDI) with RMB was allowed. In April of this year PBoC expanded the daily interval for currency trading from 0.5 percent to 1 percent, probably not because RMB is significantly undervalued, but to speed up the internationalization. There are three steps in this internationalization, and China has partly taken the first two: use of RMB in trade and investment settlements. The third and final step is for RMB to become a reserve currency. There is a long way left until China is there. The currency could fully convertible within a ten-year period, however, if the other financial reforms are implemented. Since 2005 the real effective exchange rate has appreciated by 27 percent and the nominal rate by 21 percent. Against both the US dollar and euro, the renminbi has appreciated by about 25 percent. After a lengthy period of criticism of PBoC for keeping the exchange rate undervalued, it now seems to be closer to its equilibrium rate (though it’s hard to say exactly). The current account surplus shrunk from about 7 percent of GDP to about 3 percent between 2007 and 2011. Trading quoted in RMB doubled in 2011 and reached RMB 2 100 billion (USD 330 billion) or 9 percent of total trading last year. Expectations are that the renminbi will further strengthen as China’s market orientation continues. Further internationalization could be prevented if concerns about speculative inflows increase when the currency is expected to appreciate, if reforms affecting interest rates, banks, bond markets, etc. are not pursued sufficiently, or if the

Fragmentation and too many uncoordinated regulators could be a stumbling block, however

The currency has appreciated by nearly 30 percent and no longer seems undervalued

Will China’s Ministry of Commerce oppose a stronger currency?

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Chinese Ministry of Commerce opposes reforms that would strengthen the value of the currency and therefore hurt exports.
Exchange rates

4. Opening the capital account Now that Chinese companies are investing abroad, reversing foreign direct investments, Chinese banks have to be more sophisticated and follow their customers. Chinese banks already have 150 branches outside the country, with more sure to follow (Bank of China has just over 60 percent of them). Last year 13 500 Chinese companies were involved in more than 18 000 foreign companies in 177 countries and regions, mainly in Asia. More than 90 percent of China’s investment outflow comes from state-owned enterprises. They can now use RMB in their investments, thereby reducing their exchange rate risks. Liberalization of China’s current account was the first step (back in 1996), but now the capital account has to be liberalized as well. This would allow foreigners to make investments in China’s capital markets and Chinese to invest abroad. It would also increase competition for the Chinese, who would have to compete for financing with foreigners. China’s capital account is partially open. Foreigners can buy “B” shares, while “A” shares are limited through a quota system (QFII). Chinese investors can buy foreign shares through the so-called QDII fund. The quotas are gradually increased. A pilot project currently under way in Wenshou which allows individuals to invest abroad will probably spread throughout the country. Progress could be derailed if other financial reforms lag. Furthermore, Chinese politicians have the global financial crisis fresh in their memories. Many feel that capital controls saved China from the volatile capital flows other Asian countries suffered from during the Asian crisis in 1997-98 and again during the global financial crisis in 2008-09. Nevertheless, the 12th development plan promised a
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The current account balance was much easier to deregulate than the capital account

Chinese politicians claim that capital controls have been good for stability

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liberalization of the capital account by 2015, as well as expanded RMB convertibility. This will probably still include some capital controls, certainly to prevent speculative capital flows.

5. Consequences for the global economy
The global economy as a whole would benefit if China instead chose a path of slower, more sustainable economy growth, relied on consumers to drive the economy, and continued the gradual, cautious deregulation of its financial sector. For countries and companies with a business model that requires continued investment-led Chinese growth, such a correction toward slower growth would naturally have an impact. This also applies to Swedish companies that focus on commodities and manufacturing. Companies that have adopted a long-term attitude and focus on quality, sustainable (organic) products for both producers and consumers have more to look forward to. China has to transition to a value model that raises quality, abandon its throw-away mentality and become more environmentally conscious. The middle class is growing in size and becoming better educated. They can gradually begin to dip into their high savings (as already seen among the younger generation, who would rather spend on capital goods than keep their money in worthless bank accounts). All foreign companies have to stay informed about the accelerating changes that are coming in connection with the deregulation of the financial sector. It could mean the expansion of quotas for foreign investors, interest rate reforms, new forms of financing, etc. Companies that are now active may feel growing price pressure after the economy has slowed, liquidity has dried up and overcapacity is an issue. If China opens up its financial sector and creates a greater market orientation of production factors such as land, capital, etc., we could expect to see lower savings imbalances in the global economy. It is important, however, not to be overconfident how quickly and easily the financial sector can be deregulated. For one thing, it is extremely hard to rebalance an economy. For another, many countries have found it difficult to deregulate without the risk of creating bubbles. In China's case it is likely that the risk of financial bubbles would grow over time if the financial sector isn’t deregulated. It will take time before the renminbi becomes a reserve currency. It still has a long way to go. China would have to reduce its dependence on exports, so that it no longer has to accept the US dollar, euro or yen and can dictate payment terms in renminbi. The renminbi also has to become more liquid, which could be done by expanding China’s capital market from today’s 4 percent of the global capital market (compared with the US with 38 percent and the euro zone with 22 percent). It is also important that China begins to export its currency, e.g., by importing more and letting Chinese invest abroad, so that capital not only flows in but also out. China will continue its cautious financial reforms Overcapacity could lead to increased price pressure Companies with old business models are hurting, while those with more modern models are benefiting The world should hope for slower, more balanced growth

Little likelihood that the renminbi will become a reserve currency at this point

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To develop a reserve currency, there has to be confidence in the economy and probably the political system as well. China is on its way to developing the world's third largest bond market, but there is no track record of a dictatorship that enjoys such confidence in the financial market. We don’t know how decisions are made and whether investors can be sure their investments are safe. It takes time to build such confidence. Deregulation of the financial sector is one step. Democratization is probably also necessary, including fighting corruption and developing a robust justice system. The steps mentioned in this report as evidence that financial deregulation is on the way in China are still small ones. Special interests will want to slow down the reform process for their personal benefit. Another question that has to be asked if whether China is in fact prepared to shoulder responsibility for the global financial markets. The party would have to give up control over the economy, address the “trilemma” described above, and would no longer be able to hide the level of bad loans in the banking system. If China chooses to take a back seat, the US, euro zone, Japan and other developed countries would have to continue to bear more of the responsibility for the global capital supply than their economic size would suggest. As a result, the Federal Reserve would have to accept generating more liquidity than the US needs domestically. When China passes the US as the world’s biggest economy later this decade (in terms of purchasing power, not in dollar terms), there will be plenty of room for differences in opinion and potentially conflicts as well. A new political leadership interested in reforms and international relations is therefore high on the wish list. Cecilia Hermansson Does China really want the renminbi to be a reserve currency with all that implies?

Economic Research Department
SE-105 34 Stockholm Telephone +46-08-5859 1000 ek.sekr@swedbank.se www.swedbank.se Legally responsible publishers Cecilia Hermansson, +46-8-5859 7720 Magnus Alvesson, +46-8-5859 3341 Jörgen Kennemar, +46-8-5859 7730 ISSN 1103-4897

Swedbank Asia Analysis is published as a service to our customers. We believe that we have used reliable sources and methods in the preparation of the analyses reported in this publication. However, we cannot guarantee the accuracy or completeness of the report and cannot be held responsible for any error or omission in the underlying material or its use. Readers are encouraged to base any (investment) decisions on other material as well. Neither Swedbank nor its employees may be held responsible for losses or damages, direct or indirect, owing to any errors or omissions in Swedbank Asia Analysis.

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