MANAGING FINANCIAL RISKS AMID CHINA'S ECONOMIC SLOWDOWN
Preface: Structural Slowdown to China's Economic Growth
1 International Economic Background of China's Economic Slowdown
Since the global financial crisis in 2008, the world economy has exhibited the following symptoms of long-term stagnation.
First, after having been plagued by the crisis for over eight years, the world economy is still deeply trapped in the quagmire of weak recovery, low growth, high unemployment, low inflation, high debt and high risks. Major problems that led to the eruption of crisis-serious distortions in the development patterns and economic, fiscal and financial structures of major countries-still persist. Moreover, nonconventional measures introduced by countries in the aftermath of the crisis have displayed increasingly negative side effects-the most significant of which include flagging return on investment, high debt and leverage ratios, excessive money supply, panic over the central bank's plan to shrink balance sheet, fiscal cliff, loose market discipline and growing social turbulence.
Second, major countries are not in sync with each other in their economic operations, as evidenced in uncertain price changes of bulk commodities, interest rate gaps, wild exchange rate volatility and rampant international hot money. Long-term and disorderly change in the macroeconomic variables of countries has created a hotbed for “carry trade”. Mass cross-border flow of international hot money that disrupted international financial markets has been a new normal of the world economy.
Third, major countries face the dilemma between “deleveraging” and “balance sheet repair” in selecting macroeconomic policies. The recent round of financial crisis was induced by the high debt-to-GDP and leverage ratios of major economies. In this sense, recovery from crisis is apparently contingent upon the necessary condition of “deleveraging”. Yet deleveraging has to overcome at least two hurdles. First, savings rate and deposits must be substantially increased to accomplish deleveraging-both of which are hard to achieve for most countries. Second, as a precondition for economic recovery, deleveraging will trigger “balance sheet repair” shocks, forcing enterprises to shift their priority from “maximizing profits” to “minimizing debts”. This will give rise to the “fallacy of composition”, where society as a whole is preoccupied with debt repayment, putting production and investment on the sidelines. As a result, the economy as a whole will be struck by credit crunch.
The fourth symptom is trade protectionism, geopolitical tension and frequent regional conflicts. Against the backdrop of a slowing economy, rising unemployment and lurking risks, governments naturally resorted to trade protectionism in the name of protecting national industries and employment, as evidenced by Brexit and the Trump administration's protectionist stance. With all these headwinds, the growth of world trade has stayed below world GDP growth for four years in a row, triggering the process of “de-globalization”.
Fifth, vacuum in global governance has appeared. Since World War II, dedicated governance institutions have been created in almost all sectors of the international community supported by specialized governance rules, best practices and norms. These institutions and rules have formed complete governance mechanisms in all sectors, and have been functioning effectively until the eruption of the recent financial crisis. Since 2007, the current global governance mechanism has failed to cope with traditional challenges and increasingly complex nonconventional challenges. It is fair to say that the international governance system dominated by advanced economies since World War II has been shaken to its foundation.
The above challenges will persist in the long run as major economies fall into long-term stagnation in the long cycle of global economic downturn. From supply side, the culprits of long-term stagnation include slow technology progress, worsening demographic structure, falling productivity and negative real interest rates. From demand side, “output gaps” continue to persist ,i.e. real growth rate is below its long-term potential for a protracted period of time. From the perspective of macroeconomic policy, monetary policy has failed under the negative equilibrium interest rate (liquidity trap). Moreover, increasingly uneven income distribution has further ruptured society and inhibited socio-economic dynamism and growth potentials.
2 China's Economy in the New Normal
While the world economy struggles with long-term stagnation, China's economy has entered into the new normal characterized by structural deceleration. Nevertheless, the slowdown of economic growth from rapid to medium-rapid growth is accompanied by an upgrade in the overall quality, efficiency, environmental performance and sustainability of China's economy. In other words, China's new normal is blessed with the positive elements of economic upgrade, refinement and restructuring in an advanced stage of development. These changes are both the extrinsic features and intrinsic causes of the new normal.
First, China's economy is experiencing structural deceleration. Save for the anomaly in 2010 caused by the fiscal stimulus policy in 2009, the slow deceleration of China's economic growth started from 2008 and the downward pressures remain unabated today. Our forecast of potential growth rates lends credence to the tendency of China's structural deceleration. As revealed by the forecast of the Macroeconomic Operation and Policy Simulation Laboratory of CASS, the range of China's potential growth rates for the three periods of 2011-2015,2016-2020and 2021-2030 is 7.8%-8.7%, 5.7%-6.6%and 5.4% and 6.3% respectively, indicating a rather significant tendency of deceleration.
The reasons for China's economic structural deceleration derive from change in factor supply efficiency. Population, capital and technology are the key drivers of economic growth. Over the past three decades, China's rapid growth has been supported by the tremendous flow of tens of millions of unemployed or semi-employed people into the manufacturing sector. However, due to falling labor participation rate and population growth since 2012, China's demographic dividend is diminishing and being replaced by demographic debt with the arrival of the Lewis turning point. In 2015, the growth rate of China's labor input fell to -0.9% for the first time in 30 years, which revealed a bleak prospect. Over the past three decades, China's capital formation rate has maintained a fairly high level under the support of high savings rate. However, diminishing demographic dividend, flagging momentum of industrialization, slowing growth of savings rate, falling return on capital and decreasing capital output ratio have caused capital input to lose steam in the absence of inflation, with the growth rate of fixed asset investment down from an average of 26% in the past three decades to 8.1% in 2016.Technology progress remains disappointing, posing long-term challenges of low return on capital and a dearth of breakthrough. According to statistics, China's labor productivity fell to 8.16%during 2008-2015 with TFP contribution to GDP down from the previous two-digit to 8.56%. Meanwhile, the output elasticity of capital is falling as well. In a nutshell, the overlapping effect of diminishing labor and capital input growth rates and slow technology progress have caused China's falling economic growth rate at the factor side of economic growth.ost o
Second, changing resource allocation efficiency. China's economic growth over the past three decades has been primarily fueled by the transfer of tremendous resources from agricultural sector to industrial sector and from inefficient primary industries to the more efficient manufacturing sector. Over the years, resource reallocation on a massive scale has brought about tremendous improvement in labor productivity. However, as China's manufacturing sector as a share in GDP became saturated and plagued by overcapacity, resources including population began to shift to tertiary industry dominated by the service sector. In 2016, the service sector already accounted for 51.6% in China's GDP, which exceeded the share of manufacturing by 11.8 percentage points. However, as is commonly the case with other countries, labor productivity of the service sector is significantly below that of the manufacturing sector. Such productivity gaps are particularly striking in China, where the service sector is normally at the bottom of the productivity scale. According to analysis by the Institute of Economics, CASS, labor productivity of China's tertiary industry was only 70% that of secondary industry during 2006-2015.Given such gaps, China's overall labor productivity will inevitably fall as more and more of the population and other economic resources move from manufacturing to the less productive service sector, thus taking a toll on growth.
Third, innovation is lacking. Over the past three decades, China's innovation agenda has been dominated by learning from other countries as productivity could be easily and continuously increased by transferring surplus labor from agriculture to the export-oriented manufacturing sector that relies on imported technology. However, when China is towards the end of completing its curriculum to catch up with other countries, there is not much to learn from overseas, or put another way, advanced countries have put up technology barriers against a rising China. In any case, the “learning by doing” model proves to be unsustainable and China must shift from dependence on technology import to indigenous innovation-a transition by no means easy to accomplish. For instance, although China ranked first in the world in 2014 in terms of the number of patent applications and was among the leading nations in terms of the publication of academic papers, China's conversion rate of patents remains in the middle globally. As recently pointed out by President Xi Jinping, “innovation cannot be accomplished as soon as papers are published and patents are obtained；innovation must be embedded in the creation of new growth drivers and be turned into practical industrial activities”. President Xi's remarks have clearly identified the crux of China's lack of innovation.
Fourth, natural resources and environmental capacity are increasingly constrained. Wasteful use of resources characterized China's extensive pattern of economic growth. Since the dawn of the century, the surging prices of energy and other bulk commodities followed by wild price volatility put a brake on China's resource-intensive growth pattern. While the environment did not receive high priority in the past, persistent smoggy weathers, serious heavy-metal exceedance in food and extensive pollution of drinking water have unfolded rampant environmental problems in China-problems that took over a century to appear in developed countries but became evident in China, a country still in its development stage. While we start to address the scourge of environmental pollution, the negative factor of natural resources and environmental constraints will be endogenously added to China's economic growth function.)
In the new normal, the basic characteristics of China's economic development are that much of its real economy has yet to find a new direction of development and that return on investment keeps falling. As a result, the financing function of the financial system is losing support and purpose. In this context, the accumulation and revelation of financial risks become inevitable.