Dec 25, 2017 07:44 PM

Opinion: Deleveraging: Put Real Economy First

It has become apparent that Chinese government’s deleveraging campaign is now targeting the real economy more than the financial system, but that does not mean the government is done with cutting the excesses out of the financial system.

In fact, over the next five years, I reckon financial regulations will become tighter, and deleveraging the industry will speed up. That is inevitable as the bloated financial system has impeded economic development, and reforming the financial sector has lagged behind reforming the state sector.

Before I dive further, I would like to clarify one concept: “Leverage” is a neutral term, not necessarily negative. Using borrowed money to increase the potential return on investments is a fundamental of any modern financial system.


The problem lies in where that borrowed money gets invested. In China, capital has been fleeing from the real economy to the financial sector since 2015. When bank assets grew more quickly than total social financing, it meant that less capital was allocated to the real economy, and more was being recycled within the financial system.

In my opinion, regulations alone are unlikely to reverse that, because the root of overleveraging is in the real economy.

Firstly, the rapid growth of corporate debt has largely been driven by the state sector, which has a mission to serve as the government’s extended arm to drive economic growth. Since the financial crisis in 2008, China’s real economy has experienced some fundamental changes. But it all boils down to loose monetary and fiscal policy — persistently low interest rates and the 4 trillion yuan ($608.2 billion) stimulus that started at the end of 2018. Compared with the private sector, state-owned enterprises (SOEs) grew more indebted. As of the end of 2015, 82.5% of the country’s nonfinancial corporate debt was held by SOEs.

Secondly, investors avoided the state sector due to its low returns, accelerating the capital flight away from the real economy. Despite the massive post-crisis economic stimulus, some of the state sectors are still plagued by overcapacity and low returns. Although earnings at SOEs have been improving in recent years, thanks in part to supply-side reforms, the improvement was brought about more by higher raw material prices or the companies’ monopoly status. Consequently, their corporate governance has not improved significantly. This is a classic case of inefficient resource allocation.

Thirdly, government investment has not kick-started private investment in the way it was supposed to. That is because they are investing in different sectors: the government focuses on public infrastructure, while the private sector is keen on the mining, manufacturing and agricultural sectors. Also, the government has invested more in high-return, monopolistic industries, somehow “crowding out” private capital in these sectors.

When financial markets were sizzling hot — for instance, during the stock market’s bull run that lasted until mid-2015 — massive capital flocked to the financial system and private investment shrank. So, we have found that expansionary monetary policy benefits SOEs first, but contractionary or deleveraging measures first hit the private sector.


Therefore, the leverage of the financial system and the real economy are two sides of the same coin. Apart from more stringent regulations, we could enhance our capabilities in the following areas.

Firstly, we could avoid unnecessary stimulation of the economy, which could be accomplished by downplaying the policy goal of “stable economic growth.” In fact, the government’s latest initiative of public-private partnerships is adding leverage, somehow encourages local authorities and SOEs to assume more debt.

We have to understand it is OK to have slowing economic growth, because productivity drops while our economy transitions to the service sector. Also, China is still suffering a labor shortage, which means we do not need stimulus to create more jobs.

Secondly, we could focus on encouraging private investment, and get rid of “soft budget constraints” in which SOEs’ losses could be absorbed by the state budget.

Thirdly, we could employ debt-to-equity swaps to help reduce leverage, especially at SOEs, and execute them in a market-oriented, lawful manner. These swaps essentially help indebted SOEs buy more time to revive themselves.

In my opinion, if we want to strengthen financial regulations and curb financial “chaos,” one of the best solutions is introducing more foreign financial institutions, because they are more concerned about risk management. Their entrance would also increase competition.

Now, as markets open, the government should first address internal economic imbalances. If the external environment becomes too challenging, temporary capital controls are sometimes is necessary. Internal economic and financial reforms must also catch up with the market opening, in order to attract more inflows.

For now, the Chinese yuan is very stable, which has created a conducive environment for more stringent financial regulations, as we have much less to worry about during reforms.

In conclusion, the essence of financial deleveraging is cutting excesses out of the real economy. Therefore, economic reform, not financial reform, should be in the front seat.

Zhong Zhengsheng is chairman and chief economist of CEBM Group, a subsidiary of Caixin Insight Group

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