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Opinion: China Needs to Invest in Its People to Stabilize Economy

In how much trouble is China’s economy? If one infers from the behavior of the Shanghai Composite Index, then the answer is “considerable.” The Shanghai Composite is down by more than 20% from its January 2018 peak. If one takes literally the conclusion of a report issued by the National Institute of Finance and Development last week, then the situation is dire. China, the Institute warned, faces an immediate danger of financial panic triggered by corporate bond defaults, a weakening currency, and declining property investment.

Certainly the external environment is increasingly unfavorable. First the U.S. Tax Cuts and Jobs Act of December 2017 and now increases in U.S. Federal Reserve interest rates have caused international liquidity to flow toward the United States, resulting in a growing scarcity of dollar funding. This has made it more difficult for Chinese enterprises with dollar-denominated debts to stay current on interest and amortization payments. Meanwhile U.S. President Donald Trump’s tariffs have cast a pall over China’s export sector and raised questions about the viability of its supply chains. Both developments will depress corporate investment going forward. Nor have these uncertainties gone unnoticed by the household sector. Retail sales have declined noticeably since March.

The question for Chinese policymakers is what to do. So far they have responded with gradual and calibrated monetary easing. Since mid-April, they have guided the yuan exchange rate 5.5% lower against the dollar, in an effort to support to the export sector. This policy of benign neglect toward the exchange rate has given the People’s Bank of China (PBOC) room to cut the required reserve ratio (RRR), freeing up $100 billion of yuan liquidity for new lending.

But this approach to supporting economic growth creates three interrelated risks. First, depreciation of the currency against the dollar will antagonize Trump and complicate efforts to contain his spreading trade war. More tariffs, if Trump is reckless enough to impose them, will swamp the benefits of a weaker exchange rate for China’s export sector.

Second, a weaker exchange rate will make it still more costly for Chinese enterprises with dollar-denominated debts to service and repay their obligations. The PBOC’s efforts to lubricate the financial system with additional yuan liquidity won’t help, since Chinese enterprises with external debts need dollars in order to service them, and the weaker exchange rate makes dollars more expensive.

Third, encouraging additional lending to enterprises and local governments to finance fixed-asset investment threatens to undo the progress achieved in reining in excesses and rebalancing the Chinese economy away from uneconomical infrastructure investment and excess capacity in old industries.

The PBOC proposes to address these concerns by requiring large banks to devote the funds freed up by the RRR cut to debt-for-equity swaps with state-owned enterprises. Such swaps will lighten the debt-servicing burdens of the SOEs. They will avoid artificially pumping up property investment, encouraging unrealistic infrastructure projects, and creating yet more excess capacity in old industries.

But in these debt-for-equity swaps, the big banks are essentially forgiving 100 yuan of debt in return for, say, every 50 yuan of equity, and using the funds freed up by the RRR cut to fill the resulting hole in their balance sheets. If the indebted enterprises had been able to offer 100 yuan of equity for 100 yuan of debt, they presumably would have floated the equity and retired the debt on their own, without the need for bank-engineered swaps.

These swaps may yet be a better deal for the banks than a legacy of nonperforming loans, but only if they’re packaged with a commitment from the enterprises receiving them to upgrade their management and restructure their operations. If not, that equity may end up being worthless, in which case the hole in bank balance sheets will grow even larger.

For all these reasons, the current approach of relying on a weaker exchange rate and liquidity injections to stabilize the Chinese economy is a strategy with risks. Specifically, were the economy to slow further it would be extremely risky to repeat it.

Better would be to bring forward some of the public spending already programmed for the second half of 2018, emphasizing education, health care and other social services as opposed to industrial investment. Better still would be to accept the reality that Chinese economic growth will now slow further, given the less favorable external environment and the exhaustion of obvious investment opportunities in heavy industry.

China needs to invest in its people rather than prioritizing an arbitrary growth target of 6.5%. Investing in its people will help it to achieve its “China 2025” goals, whether Trump likes them or not.

Barry Eichengreen is professor of economics at the University of California, Berkeley, and a former senior policy adviser at the International Monetary Fund.

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