How slower growth in China could threaten financial reforms

Low GDP could mean reforms are forgotten

The unthinkable has happened: China’s official GDP rate has slipped to 6%, its lowest level in nearly three decades. This must not be allowed to detract from much-needed reforms of the banking sector.

The way in which China calculates its GDP figures is not particularly transparent and few consider it to be a true reflection of the health of the underlying economy, instead relying on other indicators such as import and export data and electricity consumption.

But there is one very important reason for paying attention to the GDP data: what it says about government policy. By announcing such a low level of growth, Beijing appears to be signalling to the market that it should prepare for more monetary easing.

The country’s central bank has already cut the amount of cash that banks must hold as reserves three times this year, potentially freeing up hundreds of billions of renminbi for lending to the market. The authorities have also started encouraging banks to link their loans to a more market-based benchmark – the loan prime rate – rather than the official rate, thereby theoretically reducing funding costs for corporates.

Expect more government intervention to follow on the back of the 6% growth rate.

But there is perhaps another, somewhat more worrying, policy move that slower growth could herald in: the decision for China’s reformers to take their foot off the gas. As our recent article on China credit risk shows, that would be a mistake.

Two years ago, Chinese premier Li Keqiang gave a speech to the Davos economic world forum in which he stressed the importance for structural reform.

“We will step up efforts to prevent and control economic and financial risks and stave off systemic risks,” he said. “Potential risks do exist in some areas, but they are generally under control. We are taking effective measures to tackle and remove them in a timely way.”

At the time, Beijing was forging ahead with its crackdown on the murky world of off-balance sheet lending – an initiative that has arguably been successful in taking a large amount of risk out of the banking system, although this has also made it harder for companies to access cheap funding.

Despite the incredibly small amount of creditor money that was put at risk, the takeover spooked markets, with widening bond spreads reflecting investor fears about broader risks to the country’s financial system

Li Keqiang’s comments were set against a backdrop of 6.7% GDP growth and where, although weak, the economy was expected to rebound. We are now assuredly out of that territory, while the need for reform has not gone away.

A review of 30 small Chinese banks that conducted over a two-month period showed a worrying level of credit risk that could, potentially, upset other parts of the domestic financial system should it be allowed to spread.

There were some positive signs in May that the authorities might be prepared to rein in this credit risk, when it announced that creditors could be on the hook for some of the losses incurred by the collapse of Baoshang Bank.

Admittedly, the potential loss to creditors was minuscule – just 0.02% of the bank’s total funds, according to the government – but this didn’t stop people getting excited about what it meant for clamping down on future credit risk excesses.

Unfortunately, the momentum to fight this moral hazard may now be lost. Despite the incredibly small amount of creditor money that was put at risk, the takeover spooked markets, with widening bond spreads reflecting investor fears about broader risks to the country’s financial system.

With the official GDP rate now having slumped to 6%, the government may not be interested in repeating the experiment. That is a shame and could see a valuable opportunity lost. The Baoshang Bank takeover was a year in the making and, as a result, it was well understood what might happen. If – or when – another Chinese bank faces such difficulties, markets might not be quite so prepared.

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