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Why hurdles to China's deleveraging remain

China’s resolve to rein in financial risks has strengthened since mid-2016 but success remains uncertain, says S&P Global Ratings. Chinese lenders' higher tolerance for weak stand-alone credit quality at SOEs means leverage may build to a higher level than in more market-oriented economies.

China’s resolve to bring financial risks under control has strengthened since mid-2016, but the likelihood of success remains uncertain, according to S&P Global Ratings.

Can this round of credit control in China succeed?

China’s latest effort to control credit growth has better chances of success than before, in our view. Most importantly, it's because we now see better coordination among government agencies. The May 2017 policy document on local government financing published signals this. Although it mainly concerns fiscal policy, it was undersigned by five agencies -- including the key financial regulators -- other than the Finance Ministry. This is likely to mean fewer obstructions to policy measures aimed at curbing credit growth arising from differences in departmental objectives.

How is the political setting more conducive for tightening credit policy?

Many senior party leaders will change in the run-up to the party congress this autumn. These changes bring considerable personal risk to officials who implement unpopular policy changes that have doubtful support from future influential leaders. Developments in the past year or so may have reduced this risk. Many key government personnel changes have already been made. And, this close to the party congress, many analysts expect that most of the new top party leadership posts have been decided even if they are not yet announced. Current policies likely already reflect the views of these new leaders. Consequently, attitude toward measures implemented to augment financial stability are unlikely to change significantly in the near future.

Is the central government more able to rein in local government financing today?

Fiscal reforms of recent years have made possible better control of local government financing. A likely concern of policymakers is that restricting local government borrowing could cause a sharp drop in public investment and an abrupt fall in economic growth. The smooth implementation of the revised Budget Law goes some way to reducing that risk. Local governments can now issue bonds to fund their investments even if off-budget borrowing through their financing vehicles is stopped.

Also, the central government has a much better idea of the scale and variety of local government borrowings. This came from the audits of recent years that have focused on this issue. In addition, new requirements were inserted into the revised Budget Law to require more information disclosures by local governments. Building on the information gathered, the Ministry of Finance is able to monitor financing behavior of lower level governments better than before.

What obstacles do policymakers face?

The favorable conditions today do not come close to guaranteeing success in lowering financial risk. Structural factors stand in the way of any policy change to curb credit growth in China. Some of these factors reflect the characteristics of the Chinese economy. Others are related to the policy framework and the government's response function to fluctuations in economic growth.

The key factor that makes possible such a long period of high credit growth in China is the economy's strong capacity to generate savings. This is reflected in its current account surplus despite a very high level of investment. This situation is unlikely to change any time soon, and reflects the excess of domestic savings generation over investment funding needs. Due to the slowdown of capital outflows engineered by policymakers, the surplus is contributing to liquidity in the Chinese financial sector. In turn, deposit growth that result from this creates pressure on banks' profits if they cannot be lent out. The fact that household credit growth remained strong even as corporate lending growth slowed is a reflection of this.

How do State-owned enterprises (SOEs) amplify this pressure?

Other high-saving economies with even larger current account surpluses (relative to GDP) have managed to avoid very strong credit growth. In part, it's because lenders worry more about credit risks than in China. So, as firms become more indebted and credit metrics deteriorate, lenders will hesitate to lend significantly more even if deposits keep building up. Because of implicit state support, Chinese lenders have a higher tolerance for weak stand-alone credit quality at SOEs.

Consequently, leverage could build to a higher level than in more market-oriented economies.

The large state-owned sector also complicates credit policy implementation in another way. Higher funding costs to hold down credit growth are likely to hurt private sector borrowers than SOEs. This reflects the rational tendency for lenders' to prefer to lend to government-supported borrowers, which intensifies when economic uncertainties increase in a tight credit environment. This limits the room for conventional monetary policy in curbing credit growth. We expect that much of the policy tightening to be implemented with direct measures, such as selected credit restrictions on lenders and borrowers.

What other concerns stand in the way of lower financial risks?

One is the government’s reliance on direct policy tools. Exercising these tools in an opaque manner increases the risk of misunderstanding policy intentions and over-reaction by market participants. Chinese policymakers' track record of policy communication highlights this risk. From the interbank tightening of 2013 to the handling of the stock market correction in 2015 to the change to the exchange rate fixing system the same year, a lack of transparency and insufficient communications had created economic uncertainty and financial volatility in China. The current credit tightening could also create similar situations if policymakers are not careful.

And their persistence could be called into question if economic performance is significantly affected by the tightening measures. The government employs its economic growth projection as an anchor for expectations. That is why it has historically been averse to underperforming these annual real GDP growth projections (that some call targets). If, for any reason, China's economic growth threatens to come in significantly below target, it is possible that policymakers will ease credit constraints significantly again.

Finally, local governments continue to have incentives to pursue economic growth and this will need more credit growth. In recent years, the central government has made local officials accountable for excessive government debt growth in their jurisdiction. However, local officials are still likely to prioritize growth. After all, the most likely trigger for a rise in nonperforming loans in their jurisdiction is still a sharp fall in growth. The ingenuity of local officials in getting around central government restrictions on their borrowing has been a key reason why credit growth has been so high for so long.

Will slowing credit growth aid China’s sovereign credit quality?

Our negative outlook on the long-term credit ratings on China partly reflects the risk to financial stability that high credit growth brings. S&P Global Ratings believes that the resolve of China to bring financial risks under control has strengthened since mid-2016. If this stabilizes the risks related to strong credit growth, especially in the local government-related sector, it could slow or stem the deterioration in sovereign credit support. However, the obstacles to bringing down financial risks in the country remain significant. Whether the Chinese government can stabilize overall financial risks is still uncertain.

The greater seriousness of policymakers this time increases the likelihood that credit growth could be brought down to or below income growth eventually. However, this success is not certain and may also come over a relatively long time. The degree to which this policy tightening benefits sovereign rating support is also likely to be unclear for some time.

This article is authored by S&P Global Ratings sovereign analyst Kim Eng Tan

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