Monetary policy and China’s soaring leverage problem 31 May 2017

According to the Bank for International Settlements, although the overall non-financial leverage
ratio remains reasonable, the proportion of non-financial corporate borrowing to GDP in China has
surged from 99 per cent to 170 per cent since the global financial crisis. Moody’s estimates that
even this could be a significant underestimate due to credits given through unrecorded ‘shadow
banking’ transactions. The root cause of the rising leverage ratio is incomplete economic reform,
especially the government’s continued protection of state-owned enterprises (SOEs).
Disaggregated data confirm that SOEs were the main contributors to rapidly rising leverage ratios
in recent years, while the private sector actually showed signs of deleveraging. Firm-level data
compiled by China’s National Bureau of Statistics show that SOEs still take 55 per cent of total
credits but only contribute 30 per cent of total fixed asset investment. This may have been out of
concern for growing financial risks. But so far there is not a widely accepted rule as to how central
banks should respond to financial instability. Some suggest that central banks should take into
account financial conditions when making monetary policy, while others argue that central banks
should focus on conventional policy objectives such as price stability. Tightening monetary policy
increases firms’ cost of borrowing and would directly decelerate credit growth. But the leverage
ratio can also be affected by the indirect slowdown of asset accumulation due to inhibiting
economic growth. The two forces offset each other and the net effect varies with economies and
periods. Higher potential economic growth with great demand for liquidity makes the latter effect
dominant. Yet a tightening monetary policy may inhibit asset growth more than that of liability and
actually increase leverage. This implies that only a significant change of monetary policy can have a
real impact on financial variables. And central banks would need accurate forecasts of the sources
and sizes of unpredictable external financial shocks.
But what is the cost? Monetary policy is a blunt tool, and has broad impacts on the economy.
When its goal is diverted to containing financial risks, there is less focus on conventional inflation
and unemployment targets. In China, inflation and the leverage ratio have been in general moving
in opposite directions. A single monetary policy action aimed at lowering leverage will probably
push up inflation if this pattern continues.
Financial risks can be harmful and central banks should move with extreme caution in responding
to them. For China, monetary policy could help with lowering leverage. But is not the ideal tool to
deal with it.
Trying to maintain both inflation and financial stability would divert the limited power of monetary
policy and complicate the evaluation of central bank performance.
To address the surging leverage issue, the root cause of rising leverage should be addressed
through reform. China should adopt and strictly implement macro- and micro-prudential measures
to prevent systemic risks. Instead of directly targeting leverage, the PBC should take the spillover
effects to financial markets into consideration of all their decisions and closely cooperate with
financial regulators. Further financial liberalization and the removal of special protection for SOEs
are also essential.