Imposition of financial discipline to reduce moral hazard is more of a risk to Chinese economic growth in 2021 than a tightening of monetary policy. As Beijing kicks the implicit government guarantee habit and reduces liquidity available to state-owned companies, Chinese GDP growth is likely to fall short of consensus forecasts.
Focusing on the possibility of tighter monetary policy in China this year is beside the point for the following reasons:
- Chinese policymakers remain focused on reducing debt in the economy. Deleveraging is important as China’s total debt-to-GDP ratio was close to 335% at the end of June 2020, up from 302% at the end of 2019, according to the Institute of International Finance. Beijing is tightening the supply of credit to state-owned enterprises and their local government backers. Controlled deleveraging will lead to more defaults and is deflationary.
- With disinflationary forces afoot in China’s economy and a distinct absence of inflationary pressures, there is little prospect of a need to tighten monetary policy.
- In 2020, Beijing policymakers made it clear that there was to be no repeat of the sort of liquidity splurge that took place in the wake of the 2008 global financial crisis. Hence, there is no ‘policy excess’ to unwind. The combination of lower policy stimulus and strong GDP growth means China’s credit impulse is weakening.
The People’s Bank of China (PBoC) is participating in the effort to enforce discipline in the credit market by allowing some state-owned companies to default. PBOC officials have signalled that the Chinese economy’s steady rebound from depths plunged early in the pandemic crisis will allow it to unwind at least some of its stimulus measures. While we might see policy tapering by the central bank in 2021, it is too early for tightening.
Deleveraging push could hold back GDP growth
The true risk is the impact greater financial discipline has on the economy. The recent rise in bankruptcies and bond defaults – as epitomised by local state-owned enterprise defaults – indicates that Beijing has prioritised deleveraging and is retreating from the implicit government guarantee policy now that the threat to GDP growth from the pandemic has faded.
China’s resolve to cut debt and reduce financial risk has been persistent throughout the trade war and COVID-19 shocks. It has tightened control of the fintech platforms and acted to curb P2P lending.
We expect 2021 GDP growth to fall short of the consensus forecast for more than 8.0% YoY growth (according to Bloomberg). Under a controlled deleveraging process, defaults will likely rise. Beijing’s focus is the frothy USD 4 billion corporate bond market, not the market for Chinese government and policy bank bonds. Foreign investors are reckoned to have steered clear of the riskier corporate bond market as they increased allocations to Chinese debt in 2020.
Central bank to focus on liquidity support
Policy support for the economy has focused on the new sectors such as technology, services and consumption upgrading, instead of massive reflation. Unless GDP growth disappoints, China’s credit growth cycle has peaked, with the credit impulse topping out (see exhibit 1).
This leaves the central bank with the job of sustaining the economic recovery with sufficient liquidity and facilitating Beijing’s financial clean-up efforts without causing a credit default blowout.
Recent moves in central bank policy rates point to policy normalisation, rather than policy tightening, since economic recovery started in April 2020 (see exhibit 2). With the PBoC aiming to keeping money supply growth at the same pace as nominal GDP growth to stabilise the leverage ratio in the system, government bond yields can be expected to range between 3.0% and 3.5% in 2021.
Watching the pace of deleveraging
We foresee ‘zero tolerance’ on the part of China’s authorities with regard to misconduct or debt evasion by corporates. If all goes to plan, interest rates will not soar nor will liquidity contract. It will only grow more slowly. Beijing will use defaults as a tool to rein in moral hazard and disabuse investors of the belief that China’s state-owned companies enjoy effective government guarantees.
The policy risk is Beijing being overly confident in the economy’s resilience and deleveraging too fast. The policy insurance is aggressive easing by the PBoC if things do go amiss.
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