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China’s Great Rebalancing Act (Page 3 of 3)

Equally, as the China “high-growth story” ends, forecasts are downgraded, and headlines turn negative, it would not be surprising for both foreign and domestic players to reduce their investment and expansion plans for China. Reduced investment, while a desirable part of rebalancing, must also reduce GDP growth (absent an offsetting increase in consumption, exports or government spending). This is one of the reasons why China must slow. Yet such a “feedback” loop could push things too far and result in investment collapsing rather than reducing in an orderly, easy-to-manage fashion. Indeed, some genuinely productive investment could disappear alongside the waste as expectations about the country’s outlook change and pessimism replaces the previous euphoria.

The long journey of rebalancing on which China must embark contains numerous potential negative feedback loops, all of which will challenge political resolve. Nowhere is the potential for disruption as high as in the country’s distorted and opaque financial system.

The PBOC’s aforementioned panic-inducing squeeze on the interbank markets was aimed at parts of the shadow banking system enabling irresponsible lending, specifically wealth management products (WMPs), and the use of reverse repurchase agreements (reverse repos) to avoid regulatory risk controls. Credit (especially the shadow kind) is being used to roll-over non-performing loans. Any crackdown will seriously hit both corporate and financial sector balance sheets. Even if no bank is allowed to collapse, recapitalizing them (again) will hit existing shareholders. Recent bank share price drops are entirely justified.

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Another area of financial concern is China’s domestic bond market, which has still not seen a “real default” in which bondholders have been forced to take significant losses. This process is a necessary step if China is to achieve its goal of improving the bond market’s ability to price risk, raise funds, and allocate them to worthy borrowers. However, when the first such cases occur, they will shift the risk-benefit calculations of all bondholders. Again, the results could be as hard to manage as they are unpredictable.

Yet another potential area where unexpected consequences or feedback loops could hit is the property sector. Closely connected to the financial system, efforts to control the property market always cause concern. Indeed this fear is probably responsible for the persistent failure of the government to effectively tackle the runaway real estate market, despite several policies and numerous statements signaling an intent to do so. Whether the local bubbles pop or are gradually deflated, the construction sector affects not only its associated industries and employment, but also the value of the land which local governments have used to capitalize their financing platforms.

A tremendous amount of political resolve is necessary to stay the course through slowing growth, numerous potential mini-panics, and employment shocks. However, the alternative would prove genuinely disastrous. Although put off for many years, it seems China’s difficult rebalancing process may finally be underway.

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