In most developed countries macroeconomic management is the domain of separate fiscal and monetary policies. In China, the focus is on “financial policy”, a combination of credit, monetary and regulatory policies with powerful direct effects on growth and stability. This “financial policy” has critically shaped the structural development of the economy, fostering particularly state-owned enterprises, heavy industry, and real estate. It has left the economy with a difficult legacy of inefficient credit allocation, bloated shadow banking, and financial systemic risk in the real estate sector. Reforms since 2016 seek to normalize China’s macroeconomic policies but have created severe tensions between the objectives of deleveraging and sufficient growth.

Chen Kaiji and Tao Zha (2018), “Macroeconomic Effects of China’s Financial Policies”, Federal Reserve Bank of Atlanta, Working Paper 2018-12, November 2018

This post ties in with SRSV’s summary lecture on systemic risk through emerging markets and China’s financial system.
The below are excerpts from the paper. Emphasis and cursive text have been added.

What is financial policy?

“We define financial policies in China as a set of credit policy, monetary policy, and regulatory policy. “

Credit policy in China plays an essential role in directing banks’ credits to different sectors or firms. Such a policy consists of a number of administrative tools such as loan quotas and window guidance to limiting credits to specific sectors or industries…The People’s Bank of China utilized window guidance to control the total volume of bank credits and to redirect loans to the targeted industries (e.g., real estate and infrastructure). Such loans were made regardless of prevailing interest rates. In line with M2 growth, the People’s Bank of China planned the aggregate credit supply for the coming year at the end of each year and then negotiated with individual commercial banks to redirect credits to targeted industries when necessary during the coming year.”

Monetary policy in China has always aimed to control the money supply and aggregate credit, even until today…In May 1998, open market operations were initiated to serve as the main tool for the People’s Bank of China to manage the money supply on a regular basis. In addition, the People’s Bank of China used reserve requirements to adjust the banks’ liquidity. From then to the end of 2017, China adhered to this quantity-based monetary policy framework…Monetary policy…has [in recent years] undergone a gradual transition from the quantity based framework to the interest-rate based framework…In 2018Q1, for the first time since 1998, the M2 growth target was no longer among the government’s key economic objects.”

Regulatory policy…went through the three phases. In the first phase in which the state banks were fully owned and managed by the government, administrative tools were used to control bank credit advancements while the system for regulation and supervision on nonbanking financial companies was immature and loose.
In the second phase, the loan-to-deposit ratio (LDR) regulation became one of the most important components of regulatory policy; it requires a commercial bank to keep the ratio of its loans to its deposits under 75%. The LDR regulation was established in 1994, but it was not credibly enforced until the late 2000s. The second most important component of regulatory policy is the restriction of advancement of bank credits to certain risky industries.
Deleveraging has become a priority for the financial policies in the third phase…In March 2017, the Report on the Work of the Government (RWG) made it a priority to deleverage overcapacity firms that supported the real estate… In April 2018, the first meeting of the Central Financial Commission emphasized the importance of deleveraging zombie firms associated with local government debts.”

China’s financial policies work through transmission channels different from those in developed economies. Bank credits have always played a special role in promoting China’s economic growth. And the government has always given preferential credits to certain firms or industries, although the preference has shifted through the three different phases.

How has financial policy evolved in China?

“The Chinese economy has undergone three major phases. The first phase (1978-1997) marks an economy led by growth and reforms of state owned enterprises (SOEs). The economy in the second phase (1998-2015) was driven by investment in large and capital-intensive enterprises, which form what we call ‘the heavy sector.’ In recent years (2016- present), we have witnessed a transition to what the Chinese government calls ‘a new normal economy’.”

The state-owned enterprises-led economy (1978 – 1997)

“In the SOE-led economy, SOEs permeated through the whole economy, including all the industries and across the light and heavy sectors. Monetary policy was the main financial policy in allocating credit quotas to the banking system that channelled most of its loans to SOEs…Under the central government’s pro-growth policy and local government’s GDP growth tournament, SOEs…obtained implicit government guarantees of their bank credits…[leading to] high shares of SOEs in fixed asset investment and in bank loans to investment…Booms and busts of investment and its credits were driven mainly by SOEs.”

Credit policy was essential to promoting both investment and consumption…The fluctuation of GDP was driven by [joint] the fluctuations of both…The correlation between investment and consumption growth rates during 1978-1997 is as high as 0.80.”

The investment-driven economy (1998-2015)

“The period 1998-2015 marks an economy qualitatively different from the SOE-led economy. The most conspicuous difference was a change from the government’s direct credit control policy to explicitly targeting growth of M2 supply as an effective way to control aggregate bank loans. Such monetary policy was designed to provide adequate and accurate liquidity to the banking system to support investment in the heavy sector, which includes both large SOEs and large privately owned enterprises…The most striking facet of the investment-driven economy is that GDP growth was driven mostly by investment (so-called capital deepening)”

“The investment-driven economy experienced three distinct episodes: the golden decade (1998-2008), the stimulus period (2009), and the post-stimulus period (2010-2015).”

Golden decade (1998-208)

“Decentralization of the banking system…ironically led to the concentration of large loans to large firms….Local governments’ implicit guarantees on credits to the real estate and its supporting heavy industries played a crucial role in credit allocations…When assessing loan applications, banks…were biased against small loans to small firms… Compared to small firms, large firms produced more sales, provided more tax revenues, and helped boost GDP of the local economy—the most important criterion for the political benefits of local government officials.”

“Investment during the golden decade was fuelled by long-term bank credits at the sacrifice of short-term bank credits to working capital in the light sector…gross output in the heavy sector increased much faster than gross output in the light sector… Since the heavy sector had a higher investment rate than the light sector, the ratio of aggregate investment to aggregate output kept increasing during the golden decade.”

Stimulus period (2009)

“In November 2008, the State Council announced a plan to inject 4 trillion RMB liquidity into the economy over the two-year period from 2009Q1 to 2010Q4. The plan listed ten areas with real estate as the number one area for massive investment. As it turned out, the monetary injection was far larger than 4 trillion within the first three quarters of 2009…The real estate industry benefited the most.”

Investment was mainly financed by massive credit injections engineered by loosening monetary policy…Monetary stimulus played a pivotal role in the recovery of GDP growth, but the asymmetric credit allocation during the golden decade was exacerbated during the stimulus period.”

“An important part of financial stimulation was through the establishment of local government financing vehicles (LGFVs). Although local governments were legally prohibited from borrowing or running budget deficits, they circumvented the budget laws in 2009 and 2010 by creating off-balance-sheet companies… to finance investment in infrastructure and other commercial projects. LGFV borrowing as a percent of GDP increased from 16.3% in 2008 to 25.09% in 2010.”

Post-stimulus period (2010-2015)

“While monetary policy tightened after the 2009 stimulus, regulatory policy on shadow banking remained lax, which gave rise to the boom of shadow banking that fuelled investment in real estate, infrastructure, and other supporting industries with excess capacity. The lack of coordination between monetary and regulatory policies gave non-state banks a strong incentive to avail themselves of the regulatory arbitrage to engage in shadow banking activities, especially in entrusted lending.”

“From 2009 to 2015, entrusted loans became the second largest financing source of loans after formal bank loans. Entrusted lending is a loan made from one nonfinancial firm to another nonfinancial firm. It was first facilitated by commercial banks off balance sheet but then brought onto the balance sheet to take advantage of lax regulatory policy…Over 60% of entrusted loans during the period from 2009 to 2015 were funnelled to the real estate and its supporting heavy industries. ..As shadow banking activities blossomed, so did investments in shadow banking products on banks’ balance sheets such as account-receivable investment and investments in non-financial companies.”

“To reduce the overstock of real estate, credit policy for mortgage financing was loosened in 2014Q4-2016Q3, which created a boom of mortgage loans and an increasing concentration of bank loans in real estate. The concentration in recent years has further raised systemic risks to the financial system.”

The new normal economy (2016 until now)

“In recent years, the Chinese central government strived to achieve a balance between GDP growth and the financial stability. The Central Economic Work Conference held in December 2014 declared for the first time that the Chinese economy entered the ‘new normal stage.’”

“Financial policies in the new normal economy feature strengthened regulations on shadow banking products and better coordination between monetary and regulatory policies…Two deleveraging processes have begun: financial deleveraging to guide banks to reduce shadow banking loans and firm deleveraging to reduce corporate debts (e.g. ceasing the rollover of corporate debts). .. The housing market and construction investment have begun to cool down.”

What are the systemic consequences of China’s financial policy?

Inefficient credit allocation

“Most industries in the heavy [capital-intensive] sector were favored by the Chinese government… The asymmetric credit allocation in favor of the heavy sector was exacerbated during the stimulus period (2009-2010). The main consequence is overstock in the real estate, overcapacity in industries supporting the real estate, and overleverage in both real and financial sectors.”

“Deleveraging [in recent years] has reduced bank credits to nonbank financial institutions and thus shadow banking loans to privately owned enterprises. At the same time, the default rates of privately owned enterprises and therefore systemic risks have increased. SOEs in upstream industries, however, have continued to receive preferential credits and remain unproductive and monopolistic….Implicit guarantees by local governments to such zombie firms make difficult the deleveraging of corporate debts…in recent years, the share of newly issued bank loans to SOEs has increased rapidly.”

Systemic importance of real estate

“The massive credit expansion during both the stimulus and post-stimulus episodes has led to rapid growth of the debt burden as a percent of GDP…Both the rapid growth of shadow banking products and the increasing concentration of bank loans on the real estate industry have raised systemic risks to the financial system. For shadow banking products, systemic risks are associated with default risks to real estate companies and LGFVs. For bank loans, systemic risks are associated with default risks to the household sector if the housing market collapses.”

Tension between growth and financial stability

Deleveraging debts, reducing overcapacity, and destocking the real estate…shows up as negative monetary policy shocks since 2014…Consideration of accumulated debts…induced the government to lower M2 growth at the sacrifice of GDP growth.”

“One unintended consequence of deleveraging is that privately owned enterprises, especially the small and medium-sized ones, have had even a harder time to gain access to bank financing. During the deleveraging processes, the tightening of regulations on the shadow banking industry has led to defaults of unprofitable privately owned enterprises, creating a trade-off between cleansing effects and systemic risks as borrowing costs for healthy privately owned enterprises have also increased. The mounting default risks, together with increasing deposit shortfalls under the financial deleveraging, have made banks more reluctant to lend to privately owned enterprises, including the healthy ones…As GDP growth continues to slow down, the tension between GDP growth and financial stability challenges the government’s determination for further deleveraging.”

New normal is not yet normal by international standards

“Monetary policy has begun to experience a regime change [since 2016]: a transition from the quantity based framework to an interest-rate based framework. In addition to the conventional policy tools, the government has applied many unconventional tools such as Standard Lending Facility (SLF), Medium-term Lending Facility (MLF), and Pledged Supplementary Lending (PSL) to assist this transition.”

Such a transition, however, will not be smooth under China’s institutional constraints. The GDP growth target still remains the foremost goal of monetary policy. According to the central government’s Thirteenth Five-Year Plan (2016-2020), the GDP growth target as a lower bound will continue for the next five years…The heavy hand of government in influencing how commercial banks allocate their loans will continue, making M2 growth an effective tool for monetary policy not only in the past but also in the near future.