Credit stimulus not panacea

Efforts should concentrate on upgrading industrial structure and increasing government spending on public services

It is very clear that Chinese economy is slowing substantially. The Purchasing Managers' Index, a key gauge of manufacturing, fell to 50.2 in June, and other indicators, such as electricity consumption, rail cargo volume and the M1 measure of monetary supply, suggest that the economy is still facing downward pressure.

Against this backdrop, China has begun to implement fine-tuning measures to stabilize growth, while continuing to implement a proactive fiscal policy and a prudent monetary policy. Obviously, there is an expectation that we might see a return of the 2009-style credit spree to boost the economy.

In reality, the slowing of the Chinese economy at that time had begun in 2007, before the onset of the global financial crisis, partly due to a number of constraints on growth potential, for example, the increasing costs of labor, land and environmental protection. Meanwhile, at that time, in the face of inflation, a tightening monetary policy was adopted. That is to say, even without the global financial crisis, the time would have come for China to slow its growth after experiencing many years of rapid expansion.

However, the global financial crisis trapped the Chinese economy amid a weak external demand and a worsening slowdown, so it was extremely important and reasonable for China to launch a massive 4 trillion yuan ($628 billion) stimulus package in 2008, effectively helping China sail through the crisis and stabilizing the world economy over the past two years.

Now things have changed greatly. It was right to expand credit to boost investment in 2009-10, but this time a massive credit stimulus should not be regarded as a solution.

The new bank loans made during 2008-10, equivalent to 60 percent of GDP in China, fueled an investment boom; as a result, investment rose from 42 percent of GDP in 2007 to 49 percent in 2010 and 2011. This high investment rate is definitely unsustainable. A true change in the old economic development model relying heavily on investment and exports will only be possible if the credit-hungry economy is adjusted.

Usually, fast credit growth can boost economies by stimulating supply, but the current problem in the Chinese economy is not on the supply side, it's the lack of demand, especially final consumption demand.

There is no doubt that there is already an overcapacity in industries such as steel, automobiles and construction materials, leading to lower prices, a big drop in profitability and higher inventories. Under such conditions, a repeat of 2009/10's massive lending might provide a short-lived boost for the economy, but it would not really help these industries, rather, it would saddle the economy with problems of further overcapacity in the future.

It is worth noting that the investment boom of 2009-10 was mainly concentrated in infrastructure and real estate property, raising inflation expectations and housing prices. Given the importance of rebalancing the Chinese growth pattern, it does not seem appropriate to take the old path of a bank credit-based stimulus. Instead, policies should be shifted to concentrate on upgrading the industrial structure, and expansionary fiscal measures should raise government spending on health, education and pensions.

Admittedly, local government financing vehicles have played an important role in boosting the economy in the past two years, but they have become heavily indebted, and face the peak for servicing debt in the next few years. Considering that local governments in China are not really independent from the central government, the bank loans borrowed by the local governments will become, to some extent, a potential source of contingent liabilities for the central government. Therefore, there is little room for them to borrow money from banks.

Chinese banks should now prepare to live a difficult life. Before 2008, a sizeable trade surplus, along with huge amounts of capital inflow, contributed significantly to China's foreign exchange reserve, which forced the central bank to release more than 20 trillion yuan of funds, the high-energy base money, creating plenty of liquidity for the banking system. This made it easy for banks to finance investment. But with a smaller trade surplus and increasing outbound direct investment, domestic liquidity growth seems likely to face a period of retrenchment. This situation is directly reflected in a lower growth rate and the higher volatility of deposits this year in the banking sector, limiting the banks' capabilities for lending.

What's more, the recently launched new capital and liquidity management requirements also impose restrictive constraints on bank loans, and the falling profitability of Chinese enterprises is reducing the appetite for borrowing.

Although several countries' central banks took action in recent weeks by either cutting interest rates or pumping additional funds into their economies, many analysts and investors believe that loosening monetary policy will not be a complete panacea. The global economy, including both developed and emerging economies, is in an era where problems are so large as to have no easy way to address them.

China should adapt to a lower growth rate, possibly to around 7-8 percent, for the next few years. Even so, China may still be the single largest contributor to global economic growth. The IMF has forecast that China will account for 31 percent of global growth on average from 2010-13.

For the past few decades, an unprecedented GDP growth rate of above 9 percent was considered "normal" in China, and also essential for creating enough jobs. However, with the Chinese working age population (people aged 15-64) growing at only 0.5 percent per year at the moment, one third the rate of 10 years ago, the slowdown in GDP growth should be tolerable. Perhaps this is the "new normal" that China should be ready to address.

More importantly, lower GDP growth does not mean that China will lose its competitiveness, and the key issue is to maintain long-term sustainable growth that will continue to deliver the income growth necessary to improve the livelihoods of the majority of the population.

Of course, the rebalancing of an economy is always easier said than done. Avoiding a massive credit stimulus and over-investment does not automatically increase consumption. Like the costs of achieving high growth, the structural reform must come with significant costs, which may be even tougher than ever.