From a Western perspective, China’s economic situation seems to be dominated by the looming trade war with the U.S. However, structural reforms and the long-term transformation of China’s economy and financial system are accelerating as well. Almost four decades after China’s real economy was reformed and liberalized, China’s financial economy is also opening up to the world.

Our observations

• President Xi Jinping pledged to further liberalize China’s financial markets at his New Year’s speech and at the Bo’ao Forum in April. In his first public speech in May, Yi Gang, China’s new central bank governor, said that China would steadily begin to open up its financial sector. A few days later, Chinese regulators eased rules on foreign investments in securities firms and allowed for majority ownership of specific Chinese financial companies. Furthermore, China recently opened its bond market to international investors.
• Total social financing (TSF) has grown very rapidly in China in recent years, from virtually non-existent in 2002 to over 200% of Chinese GDP. TSF includes off-balance sheet forms of financing, such as loans from trust companies, wealth management products or internet financing, which are not part of the official banking system, thus sidestepping many regulatory constraints. TSF activity is generally considered an indicator of China’s banking sector, which has grown to more than $10 trillion. China’s shadow banking system is at the core of China’s deleveraging campaign to contain systematic financial risks.
• Last year, Zhou Xiaochuan, the People’s Bank of China’s (PBoC) previous governor, already warned that China might face its own “Minksy moment” because of its rapid accumulation of debt in recent years. In the past decade, China’s total debt as a percentage of GDP has doubled from 150% to 300%, with most debt concentrated in China’s private sector, especially in large state-owned enterprises (SOEs). And risks are accumulating, as 2018 has already been an almost record year for corporate bond defaults.
• On June 2018, China’s central bank cut the amount of cash commercial banks need as reserves by 50 basis points. This will release $108 billion in liquidity, used to support small and medium-sized companies (SMEs). This reserve ratio reduction (RRR) was the third this year. A few days later, the People’s Bank of China refrained from hiking its rates for interbank loans for the first time, after a Fed hike.
• In May 2018, China ran its first quarterly current account deficit since its entrance to the World Trade Organization in 2001. Although the resulting red number was largely caused by seasonal factors, both China’s current account and trade surplus are on a path of decline.
• In March 2018, China launched the first yuan-denominated crude oil futures to import the most traded commodity in its own currency instead of in U.S. dollars. Likewise, China has started issuing yuan-denominated “Belt and Road Initiative bonds” at the Shanghai exchange to finance its overseas infrastructure projects.

Connecting the dots

Early this year, China’s central bank said that it would maintain a prudent monetary policy, meaning further financial reforms and liberalization, curbing credit and TSF growth (i.e. monetary tightening) to contain financial risks in order to make the financial sector “serve the real economy”. But 2018 seems to be becoming a tumultuous year for China’s economy, with a Sino-American trade war looming. However, other structural and longer-term reforms are accelerating, increasingly transforming China’s financial system.First, China’s shrinking current account and trade surpluses arguably imply that China’s economy is modernizing, because it’s becoming less dependent on exports. This is reflected by the fact that its share of global exports seems to have peaked, but that imports growth has accelerated as a result of stronger aggregate domestic demand. Furthermore, a current account deficit is basically the difference between a country’s investments and savings. In China, we see that investments as a share of China’s GDP have decreased in recent years since its peak in 2013, thus China’s savings rate must have decreased as well, giving a further boost to domestic consumption. And indeed, China’s most recent GDP data show that consumption now accounts for almost 78% of all growth while the growth of industrial production and fixed capital investments is decelerating. As China continues to run larger deficits, it will be forced to either deplete its FX reserves or borrow money on international capital markets.That pertains to the second process, namely China’s efforts to internationalize the yuan. We have written before that China’s long-term currency strategy is to increase the yuan’s share in international transactions, in which China’s currency is still significantly underrepresented (barely 1.5% of international transactions includes the yuan) given its economic size (almost a fifth of global GDP). By making the yuan more ubiquitous in international payment traffic and capital markets, China can reduce its dependency on the U.S. by becoming less reliant on the U.S. dollar and escaping the jurisdictional reach of the U.S. Treasury (America’s financial payment systems regulate most international transactions). Furthermore, by boosting the yuan as global reserve currency, China can lure other economies into its financial sphere (e.g. countries along the BRI). This will further reinforce China’s position in global trade and affairs.Given the risks that are associated with these transitions and the looming trade war, these ambitions might put an extra strain on China’s deleveraging process. But Chinese regulators have committed to further reforming and opening up the country’s financial sector. From this perspective, the PBoC’s recent monetary policy moves can be considered structural attempts to eliminate its culture of moral hazard, on the assumption that the Chinese state will bail out large companies, instead of opting for monetary easing. For example, the recent RRR cut aims to free up resources for China’s SMEs, while putting further pressure on commercial banks to clean up bad debt, which is mainly concentrated in larger SOEs. As the PBoC has a dual mandate, like the Fed, it must maintain price stability and facilitate economic growth. But it can explicitly do so by maintaining a stable currency. From this perspective, the recent devaluation of the yuan against the U.S. dollar has been framed as a new phase in the U.S.-China trade war. But given that the gains (i.e. making China’s exports cheaper) will be outweighed by the negative consequences (e.g. capital outflows, further liquidity and credit tightening) and considering China’s ambition to internationalize the yuan, this move is more the result of China’s financial system becoming more resilient and based on market valuations (China’s currency has long been considered overvalued).

Implications

• We have written before how Asia’s financial development is accelerating, because of technological and geopolitical developments. In this process, China now assumes a leading role, illustrated by its attempts to liberalize and open up its financial markets to increase liquidity and market depth. As a result, China being the motor of Asia’s financial catch-up with the rest of the world might become a long-term strategy goal to diversify China’s economy. For example, by setting up pan-Asian payment systems in China’s financial centers, or in emerging financial hubs along the BRI.
• Given the increasing prominence of China’s economy, its multinationals and its global footprint, global financial markets and institutions will increasingly have to deal with China as a financial powerhouse. This is illustrated by last month’s inclusion of 234 China large-cap A shares (shares denominated in renminbi and traded at “mainland” stock exchanges in Shanghai and Shenzen) in the MSCI emerging market index. Nonetheless, China’s business climate and ease of doing business must improve in order to attract international investors.