A historical context to China’s ‘whatever-it-takes’ efforts to boost the economy
China has a track record of taking bold, decisive moves to address banking system challenges and restore sustained growth
CHINA’s authorities have failed to meet the market’s excessive expectations relating to its next steps in its “whatever-it-takes” efforts to restore sustained growth momentum.
However, investors can take solace in the fact that China faced a similar threat – during the 1997 to 1998 Asian/Russian crises – and responded forcefully, laying the foundation for economic growth in the early 21st century.
Recall as the Chinese economy opened up to the West in the early 1980s, provincial and local governments drove credit allocation via local government banks to facilitate local construction of roads, railways, airports and other infrastructure initiatives, as well as wider real estate lending that rapidly industrialised the nation.
This industrialisation came amid the rise of Asia’s “tiger economies” (Hong Kong, Singapore, Taiwan and South Korea) and the “tiger cubs” (Indonesia, Malaysia, Thailand and the Philippines), which emerged in their wake.
Alas, excesses in several tiger and tiger cub economies led to the 1997 Asian crisis engulfing South Korea, Thailand and Indonesia, with Malaysia and the Philippines narrowly avoiding a similar fate. The crises led to East Asian currencies weakening sharply against the US dollar.
In contrast, China’s renminbi, which fell against the US dollar earlier in 1994, strengthened by nearly 15 per cent on a real effective exchange rate basis, a meaningful shock for a very trade and foreign direct investment-dependent China economy at the time.
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Taking rapid action in response in late 1997, China implemented reform measures, including injecting 270 billion yuan (US$32 billion in 1997), accelerating the write-off of bad loans and later, establishing asset management companies to buy and restructure non-performing loans (NPLs) from state banks.
Most importantly, regulators began enforcing global standards of NPL classification, requiring banks to allocate credit on a commercial basis, similar to the recommendations of the International Monetary Fund for Asian tiger and tiger cub banks, as well as in Japan’s belated shift in the early 21st century.
Today, China has floated the prospect of one trillion yuan (S$184.7 billion) for bank recapitalisation, at less than 1 per cent of its gross domestic product. When seen in the light of the past, the decisive 1998 action – at nearly 3 per cent of 1997 GDP in new capital – dwarfs this initial proposal.
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Indeed, with foreign strategic investors providing a second stage of growth capital to China’s banks in the early-2000s, even this 3-per-cent injection in 1998 was only the start of a longer process of restructuring, and reform for the sector and the economy as a whole.
While markets are focused on this recapitalisation announcement, investors should not lose sight of another step taken by Chinese authorities in 1998 – aggressively addressing the bad-debt problem within the banking system, and simultaneously encouraging the nation’s banks to take a more commercially-oriented lending focus.
University of Chicago economist Lin Cong and Northwestern University economist Jacopo Ponticelli highlighted in their 2017 paper the dramatic shift in the lending landscape in China at the turn of the century, in light of the late-20th-century moves.
From an economy driven by provincial and local credit allocation decisions in the two decades since China’s 1978 “open door policy” from 2000 to 2008, credit allocation in the banking system became increasingly directed towards private companies, giving rise to China’s entrepreneurs of the early 21st century.
Japan belatedly pursued similar reforms under the 2002 Takenaka Plan, pairing aggressive recapitalisation of beleaguered banks with forceful structural reforms, to finally lay a foundation upon which the Japanese economy could begin the long road to recovery from its 1989 economic crash.
Cong and Ponticello highlighted that China’s post-2008 global financial crisis policy response resulted in a shift in the lending landscape towards lending to state-owned enterprises. An opportunity once again presented itself to rekindle the entrepreneurial spirit within the nation.
Both China and Japan’s experience at the turn of the century highlight the benefits of aggressive and decisive moves to address banking system challenges.
China’s rise to becoming the second-largest economy in the world in the 21st century can be attributed in part to the critical choices made at the turn of the century, to re-establish a well-capitalised, more efficient allocator of capital within the economy.
These moves laid the foundation for China’s growth, while a 1998 US Federal Reserve rate-cutting cycle and China’s 2001 ascension to the World Trade Organization (WTO) provided the demand catalysts for the economy as a whole.
Although the Fed as well as key European central banks have once again moved towards easing mode with their first rate cuts of this cycle in recent months, China faces a different external demand dynamic from that in the turn of the century – there are now more contentious trade relationships with key Western economies.
Thus, though China appears to be embarking on a journey to recapitalise its banking system and re-establish a foundation for capital allocation within its economy, it will have to continue the process of shifting the economic drivers towards increased domestic consumption, to serve as this cycle’s version of demand catalysts for its economy.
This makes the size and structure of its fiscal response in the weeks, months and even years ahead key for investors.
China equity investors reaped immediate benefits from its 1998 moves, with the MSCI China Index rallying nearly 80 per cent over three months in the wake of these recapitalisation plans.
However, investors should recognise that, following the initial euphoria in late-1998, the subsequent multi-year NPL clean-up in 1999 and beyond, including the creation of China’s asset management companies to absorb, restructure and dispose of China’s NPLs, left China equities volatile – even with the increase in investment and export demand from China’s WTO membership in 2001 driving the economy.
As a result, the journey towards establishing a new foundation for the next phase of Chinese economic growth appears to have begun, and we expect it should provide opportunities – likely different from those in the past cycle. But managing risks associated with this transformation will be key, just as it was at the turn of the century.
The writer is group chief strategist at Union Bancaire Privee, a private bank and wealth management firm
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