The Real Stimulus Choice in China

(Bloomberg Opinion) -- China's glowing first-quarter numbers brought cheer to traders and gloom to economists worried about the country's long-term trajectory. As in the past, the government seems to have purchased GDP growth at the cost of rising debt levels — a problem it had vowed to tackle as part of a tough recent deleveraging campaign.

The real risk isn't that Beijing has abandoned that campaign for yet more stimulus, however (it hasn't). It's that the stimulus doesn't work.

The first thing to understand is that it's a misnomer to call the recent reform effort “deleveraging.” Unquestionably, Beijing's long-term goal is to reduce — or at least stabilize — debt levels relative to the size of the economy. But, given that China's economic model is still dependent upon debt-enabled investment to deliver politically acceptable levels of growth, that's pretty much impossible for now.

Recent efforts have instead been directed at the government's real goal: making the financial system safer. The China Banking and Insurance Regulatory Commission is focused on mitigating the risk of contagion along multiple fronts: rolling back lending between banks and other financial institutions; preventing the system from feeding credit into blatantly speculative activities; migrating risk from shadow lenders back to the formal banking system; and improving bank asset quality.

Judged on those terms, the results are promising. Shadow banking has contracted, as has interbank lending. Efforts by institutions to dispose of nonperforming loans more quickly are themselves a form of deleveraging. All of this has massively reduced the amount of complexity in the financial system and put the regulators in a better position to manage risk.

It's also increased the system's capacity to safely support higher levels of debt. That's where the current stimulus comes in. Rather than a free-for-all where banks and shadow banks are given the freedom to shovel as much credit as possible into the economy — which broadly describes the approach pursued repeatedly between 2009 and 2016 — the current effort is targeted and limited only to banks (which have been chastened since their freewheeling days) and the bond market.

This time the stimulus is focused on tax cuts, local government bond issuance to support investment in public works, and providing banks with liquidity expressly for the purpose of lending to small firms.

Those measures have been designed specifically to avoid undoing regulators' progress in reducing risk in the last two years. Indeed, rather than contradicting the deleveraging campaign, it represents a commitment to making that campaign successful.

Anyone concerned about reducing debt should hope this level of stimulus is sufficient. Beijing's room for maneuver is shrinking. Economic pain is mounting, with officials growing more vocal in their concerns about unemployment and private-sector stress. And far more credit is required to generate far lower levels of growth. A truly severe slowdown would put pressure on officials to sanction another old-style, free-for-all spending spree.

That would only make China's ultimate reckoning more devastating. In March 2017, former Finance Minister Lou Jiwei warned of what would happen if the country continued to waste the time it had bought with previous stimulus efforts: “The space to maneuver will get smaller and smaller,” Lou said. “When reform finally comes … the pain will be more severe, it will be harder to reach a consensus, and it will be easy to slide into far-right or far-left populism.”

Would-be reformers should welcome the flexibility and stability purchased by the recent stimulus. If leaders don't use that time wisely, though, the next credit boost could put China in a pretty deep hole.

To contact the editor responsible for this story: Nisid Hajari at nhajari@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Dinny McMahon is a fellow at MacroPolo, the Paulson Institute's think tank. He is the author of "China's Great Wall of Debt: Shadow Banks, Ghost Cities, Massive Loans and the End of the Chinese Miracle."

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