The recent Central Economic Work Conference set the general principles and framework for macro-economic policies in 2021 and outlined eight key missions. The bigger context is the “double-six” policy, i.e. to ensure security in the six areas of employment, basic living needs, operations of market entities, food and energy security, stable industrial and supply chains, and the normal functioning of primary-level governments and to keep employment, the financial sector, foreign trade, foreign and domestic investments, and expectations stable. In line with these goals, the central authorities aim to refine macro-economic regulation to achieve the twin objectives of economic recovery and risk prevention in a way that does not entail avoid sudden policy shifts.
This paper presents some of my thoughts on how to understand the abstract policy statement and translate it into action. What is meant by “sudden policy shifts”? When will we know the balance between economic recovery and risk prevention is achieved?
At the implementation level, the issues that come up are real and interconnected. Any deviation from the policy guidance of the central authorities could lead to tensions between the three critical tasks of reform, development, and stability, a recurring problem over the past 40 years, and failure to reach the multiple targets set by the government.
For instance, considerable risks built up over the past few years with P2P lending and asset management causing asset losses. Calling in a loan before it is mature will put many small and micro-enterprises in a precarious financial situation. Protecting the operation of these market entities is part of the “double six” policy? How does this balance with the need to contain risks?
Another example is local government debt. Local governments will need to stop issuing bonds as a way of rolling over their debt in order to put the risk of their hidden debt under control. But this may immediately expose their crushing levels of debt. Either local public finance will run into trouble, or projects under construction will screech to a halt. In this case, how do we avoid “sudden shifts”?
To implement the strategy of “dual circulation”, consumption is critical. The provision of public goods, such as education, healthcare, and old-age care, must be increased. With many local governments already living beyond their means and surviving on the transfer payment of the central government, how are they going to increase welfare spending and keep their risks under control?
As China advances its land system reform, proceeds from land sales will be used primarily for rural development, agriculture, and support for farmers. In urban areas, long-term policies will be introduced on a larger scale to tackle real estate market speculation. Tier three and tier four cities will see dwindling land revenues. Debt risks will rise and construction projects may be put on hold. How does a local government realize a trade-off between reform, development, and stability?
Examples like these show that to avoid “sudden policy shifts” and “achieve the twin goals of economic recovery and risk prevention”, it is important to appreciate the full extent of China’s financial risks and always bear in mind the general picture and the three tasks of reform, development and stability in determining the pace of risk mitigation.
First, the definition of financial risks must be well understood. The risks or hidden dangers we usually talk about in relation to the financial system are the risks and losses that have not shown themselves. When a borrower defaults, losses are incurred and the risk ceases to be a hidden one but becomes real. The only question left is whether it will be the debtor or creditor who suffers the losses.
Second, what happens when a risk is exposed and requires handling? It means someone will pay. Someone’s balance sheet will suffer. The question of “who” is critical. Macro-economic regulators must always ask themselves whose balance sheet will be affected by a certain risk, which credit policies will be undermined, and what the impact will be on the macro-economy and reform programs. Individual investors cannot always be shielded from losses; but, for the sake of social stability, it must be clear what kind of losses must be borne by them and to what extent they can bear them. When businesses are the ones to pay and small and medium-sized enterprises are already shunned by financiers, regulators must remember they have the responsibility to protect the operation of market entities. They must decide whom to protect. When it is a local government who should pay and it is dependent on central government handouts, how will it find the resources to pay? Will it be forced to sell its office building or try some undesirable means? If these risks cannot be contained at the lower levels but have to be transferred to the central government, what is the maximum deficit target the National People’s Congress may pass? If raising budget deficit alone is not enough and bonds have to be issued, what is the best way to divide the debt burden between the two? To what extent can we increase the deficit without threatening national economic security? If commercial banks suffer losses and compromise their asset quality, how will the stock market react? When all responsible parties have paid and still some risks have to be handled by the monetary policy of the central bank, we all know what that means. To put it simply, risk management is about taking losses, reducing private funds, and putting downward pressure on the economy. If rigid payment is always expected, market cannot effectively allocate resources; but if rigid payment is not going to happen, regulators need to understand to whom the losses will happen and be fully prepared.
Third, regulators must know the aggregate risks. China is still absorbing the effects of the previous economic stimulus policies. Existing financial risks and hidden dangers are built up over many years of blind pursuit of bigger GDP numbers and absent financial regulations. Trillions of yuan of troubled assets have been disposed of after over 5,000 P2P lenders were closed; commercial banks dealt with millions of yuan of off-balance sheet assets; trust funds and various financial holding companies had a large volume of troubled assets; over 7.1 trillion yuan of troubled assets have been disposed of by commercial banks between 2017 and 2019, including 5.7 trillion yuan of NPLs and debt-for-equity swaps. Aside from these risks that have been mitigated, how much risks remain lurking? Whose balance sheets are under threat? Which financial entities may default? If macro-economic regulators cannot anticipate and gauge the full extent of risks and communicate poorly with monetary authorities, they will not have the right amount and structure of monetary policy support in risk mitigation. In that case, they will find it difficult to prescribe the right intensity of policies, be it moderate, accommodative, or tight. This affects economic recovery at the macro level and the balance between growth and risk management.
Fourth, the pace with which risks are handled must be determined in line with the progress in reform and development. Across the world, two approaches dominate the disposal of risks: one is the market-based, law-based approach whereby debtors declare bankrupt when they cannot meet the legal deadline; the other is government-led efforts whereby rigid payment is made. The second one is more common in China. Debtors can miss their deadlines and do not go bankrupt and creditor’s rights and debts are repeatedly postponed, giving birth to “Zombie enterprises”.
Risk settlement and economic growth interact in the following way: when risks are released, market entities have a smaller balance sheet and less financial resources for growth, putting downward pressure on the economy; in the long run, this clearing of the market will create energy for quality growth. When risks are not released, the large number of “zombie enterprises” clog up money circulation and may result in stagflation with the total monetary supply unchanged. With regard to reform, clearing up risks from the market favors sustained growth; if these risks are allowed to continue to build, reforms will not be meaningful enough to unleash the power of market. For genuine market-oriented reform to take place, the market must be cleared. In a government-led model of risk settlement, public finance will be strained when we move too fast, constricting the capacity for social security development and other initiatives that improve the living standards. But in the mid to long-term, the faster we move in reforms and risk management, the more efficient and sustainable growth will be and social welfare will also be boosted. The question, therefore, boils down to striking the right balance between the short and the long term in order to meet the goal of maintaining stability and pursuing progress. This is a demanding job for regulators. They need to be clear about the aggregate risks and properly manage the dynamics between risk containment, reform and development. This has been the most critical question as China strives to maintain stability and sustainable development in the process of economic and social transformation.
Fifth, the lag in regulations is also a source of risk. Financial regulation is the gatekeeper against financial risks. The timing in introducing new policies matters. In the past six to seven years, financial regulation did not respond in time when thousands of P2P lenders emerged and competed fiercely, financial holding companies operated without constraints, local hidden debt ballooned, and commercial banks engaged in off-balance sheet business. In the end, the central authorities had to step in to caution against systemic risks. These lessons must be learned. Asset management is particularly challenging. New regulations in this area were often postponed, as the risk exposure can be extensive and monetary volumes huge. In the early days of Internet finance, Chinese regulators were also hesitant about keeping too tight a leash on financial innovation. The nature of financial activities was not fully appreciated. Direct regulation was missing and regulation in general was loosened. The regulatory control in place today is completely right and necessary. But it only came at a high cost. While sudden policy shifts are to be avoided, we must keep in mind the risks as well as the volumes of assets involved; when we are working on the risks, we must also know a slowdown in the economy will impede reform and efforts to resolve the most fundamental challenges as China moves towards the “dual circulation”. The financial regulatory framework should be enhanced to be more responsive. It must be able to support normalcy in economic activities and reforms, keep systemic risks at bay, and defuse various kinds of risks at the right pace and with robust policies.
