Factor price reforms and their macroeconomic policy impact

A key component of financial reform is to allow factor prices, or input prices, to better reflect economic fundamentals, rather than being controlled by policies. The government has implemented measured liberalisation of interest rates and exchange rates over the past 10 years. While the need for financial reforms to support sustainable growth is accepted in principle among policy-making circles, the timing and the pace have always been controversial as losses in the near term will concentrate on certain segments of the economy, while benefits will be widely dispersed.

The move towards interest rate liberalisation amid weak domestic growth and ultra-low global rates has proven particularly controversial. The reform pains are viewed as acute during economic downturns, such as the one at present marked by sluggish global demand, China's own structural impediments and a downturn of the construction cycle. For instance, bank lending has tended to favour state-owned companies, and overcapacity and high leverage are already placing a heavy burden on these sectors that need to reform.

Adding to this pressure are interest rate reforms, which have occurred incrementally but are already having an impact, which tend to push up the borrowing costs of banks. In particular, the rapid increase of ‘wealth management products' offered by banks and other financial institutions effectively puts pressure on banks' borrowing costs from savers - either directly or indirectly through competition. Better risk pricing should also be reflected in an increase of the credit spread between good and bad borrowers. Both developments will lead to an increase in the cost of funding for weak companies - at present concentrated in cyclical sectors and exhibiting overcapacity. Therefore, interest rate reforms tend to push up the risk-free rate, and widen the credit spread between good and bad borrowers.

Easing of monetary policy?

Should monetary policy be eased substantially because of this structural change? A higher interest rate, and in particularly higher borrowing costs for weak borrowers, would force economic restructuring towards higher efficiency and better allocation of capital, which is an intended result of interest rate reforms. The overall impact on the corporate sector will be partly offset by the relaxation of the overall financial envelope. In the past, financial repression comprised low interest rates and credit rationing. With financial reforms, loan quotas are being relaxed (such as the latest change in the calculation of the loan/deposit ratios), allowing more lending to take place at a somewhat higher average rate than before. For those borrowers that had to rely on self-financing before, the deregulation of non-bank financing helps to lower their funding costs.

A higher interest rate is therefore perhaps a necessary process  for China's reform and transition. China's structural problems have manifested themselves into rising leverage in recent years. Loosening monetary conditions will perpetuate some of these problems.

Learning from Japan's mistakes

The Japanese experience has served as a cautionary tale, where loose monetary policy can delay necessary adjustment. The Japanese experience in the 1990s, when ‘zombie' companies were given a lifeline via low interest rates and loose monetary policy conditions, wasted financial resources and dragged down longterm growth.

Timing is also a factor: China is moving quickly towards an ageing society, so politically difficult reforms will need to be conducted during a period when growth fundamentals still remain relatively favourable. The former research chief of the People's Bank of China (PBOC), Jin Zhongxia, who is now executive director at the International Monetary Fund, discusses how interest rate liberalisation should be
pursued with an eye towards macroeconomic conditions (see box below).

There is another (albeit comparatively easier-to-manage) challenge: China is liberalising interest rates in a world economy where central banks have deployed extraordinarily low interest rates and quantitative easing to hold down long-term rates. The interest rate gap between China and developed economies widened substantially in 2013 and early 2014, before narrowing in the second half of 2014 as inflation pressures in China declined. While the interest rate gap has narrowed, it will likely remain positive, putting pressure on the exchange rate.

Two trends have so far balanced this pressure. The first is the portfolio diversification of Chinese residents into overseas housing and equities. The second is the fast expansion of global investment by Chinese companies and state sectors (see section three, pp. 59-84). Therefore, despite the positive interest rate gap, there has been little reserve accumulation since early 2014, and capital flow pressure should continue to ease as the US enters its phase of likely interest rate hikes.

Constraints on significant monetary easing during the cyclical downturn are partly balanced out by the more active fiscal stance now pursued by the Chinese government. The annual budget announced during the National People's Congress (NPC) meeting in March 2015 envisaged an increase of fiscal deficit from the previous year (2.3% of GDP in 2015 versus 2.1% of GDP in 2014). In fact, finance minister Lou Jiwei said the underlying deficit target is still higher, amounting to 2.7% of GDP, once adjustments have been made for technical factors. In addition, the government now plans to "appropriately issue project-linked government bonds", implying a more explicit use of fiscal tools to support the economy during the economic downturn.

In light of the still-modest government debt (less than 50% of GDP) and the robust balance sheet of the government, a more active fiscal stance should ensure a favourable balance between growth and financial reforms.