A senior Chinese central bank official proposed on May 21 to allow China’s currency to strengthen as a counterweight to rising commodity prices, wire services report.

Lu Jinzhong, the research director at the People’s Bank of China, wrote that with China “an important commodity consumer in the world, the imported impact from international prices is inevitable.”

Lu added that China should “enhance the flexibility of the exchange rate, and let the renminbi (yuan) appreciate appropriately to offset the imported effect.”

While the United States creates demand at a record peacetime rate through massive deficit spending and ultra-expensive monetary policy, China’s central bank and regulators want to taper credit growth from banks and suppress shadow financing across the economy.

Credit restraint is consistent with a stronger RMB. During the past several months the regulators have, among other measures:

  • forced Ant Financial, the country’s largest consumer payments and lending franchise, to become a bank holding company subject to stringent reserve requirements;
  • allowed Huarong Asset Management, a distressed-debt manager that is majority-owned by the Ministry of Finance, to go to the brink of reorganization with likely losses for bondholders;
  • shut down internet platforms offering high-interest loans to Chinese students;
  • fined or suspended major rating agencies for having assigned top credit ratings to bond issuers that then defaulted shortly after the ratings had been assigned;
  • encouraged corporations to issue equity instead of debt;
  • ordered real estate companies to report off-balance-sheet loans taken out through special purpose vehicles; and
  • told local government financing vehicles (LGFV’s) to restructure, rather than expect a central government bailout, if they can’t meet debt-service obligations.

Regulators, meanwhile, have told China’s state banks to reduce lending growth. The annualized growth rate of total credit provision to China’s private sector fell to about 8% during 2021’s first quarter, according to the Bank for International Settlements.

China’s policy is coherent, although its implementation has been somewhat chaotic.

Chinese regulators shocked capital markets by suspending Ant Financial’s planned US$230 billion Initial Public Offering during the first week of November 2021 – a last minute decision justified by Ant’s excessive leverage, but announced in what appeared to be an arbitrary way.

In some cases regulators were late to identify dangerous pockets of leverage.

The perpetual preferred debt of Huarong Asset Management, for example, was packaged into high-yielding levered structures by brokers and sold to private investors. When the price of the preferred notes began to fall after Huarong missed its March 31 deadline for filing financial statements, the structured notes were unwound.

That created the equivalent of a giant margin call that drove them down to a dollar price of $53.

Is China over-leveraged? Goldman Sachs economists argued in a March 19 report that it isn’t. “Policy normalization began in China in the second half of 2020, and we expect the monetary policy stance to remain neutral for 2021,” Kenneth Ho and Chakki Ting wrote in a client report.

“We expect Total Social Financing to grow in line with nominal GDP, and we are forecasting non-financial debt/GDP to drop moderately to 282% by the end of this year,” they added. “We believe China aims to maintain a long-term path of steady leverage and rising per capita income.”

The Goldman Sachs economists argue that China isn’t overextended because leverage is roughly in line with personal income. The richer the country in terms of GDP per capita, they observe, the higher the leverage.

Below I reconstruct the relationship between per capita GDP and overall leverage reported by Ho and Ting, with two important changes. First, I use Purchasing Power Parity GDP per capita as reported by the International Monetary Fund rather than dollar GDP. The Chinese yuan undervalued in terms of purchasing power, and PPP provides a better benchmark.

Second, I take into consideration current account deficit or surplus. Countries that take in more money in exchange of goods and services than they pay out have flexibility in managing internal credit problems. They can lend all the money they want to themselves as long as they don’t have to borrow from foreigners.

The chart above is a scatter plot of each country’s leverage (nonfinancial debt as a percent of GDP) compared with its GDP per capita, calculated on the basis of purchasing power parity. The added dimension is the current account deficit or surplus; this is shown in the size of the balloons.

For example, no one worries about Singapore’s debt-to-GDP ratio of 350%, much higher than China’s 285%. That’s because Singapore has an enormous current account surplus. The country whose debt-to-GDP ratio is farthest above the regression line versus per capita income is Japan. But Japan also has a large current account surplus.

China also has a debt-to-GDP ratio above the regression line, but it has a respectable current surplus (of about 2% of GDP). Next to China is Portugal, which also has a high debt-to-GDP ratio, but with a current account deficit.

A country that runs a current account surplus for a prolonged period of time accumulates foreign assets. Japan’s net foreign international investment is about $3.7 trillion, and China’s stands around $2.1 trillion. The US net international investment position is negative $14 trillion.

No country with a current account surplus and a strong net foreign asset position has ever had a serious financial crisis. Reorganization of internal debt is another matter.

The Goldman Sachs economists believe that Chinese regulators have defused a credit problem that some analysts considered a time bomb: local government financing vehicles.

“We estimate that LGFV debt accounted for 51% of the total debt related to the Chinese government at the end of last year, down from 68% at the end of 2014,” Ho and Ting wrote. “This indicates that efforts to reduce local government’s reliance on LGFVs for funding followed a multi-year trend, and policymakers have dealt with the implicit debt problem at a gradual pace. However, we expect to see a greater slowdown in LGFV debt growth in 2021.”

They add: “The State Council recently stated that LGFVs should no longer undertake government financing roles, and insolvent LGFVs should be restructured or liquidated. This focus on LGFV indebtedness is the key reason why we expect LGFV debt stock to increase by just 7.6% in 2021, the slowest pace of growth amongst the major types of borrowers.”

Property developers now are the regulators’ main source of concern. China’s home price-to-income ratio is between 30 and 40 times (and up to 50 times in tier-one cities like Shanghai, Beijing and Shenzhen). That constrains family formation at a moment when China is preoccupied with zero population growth.

China’s regulators are in something of a bind; if they stop credit to the residential real estate market and push down prices, the wealth of Chinese families will decline, but if they allow home price increases to continue, they will make home ownership all the less affordable for Chinese families.

The best they can do is to try to keep home prices stable and wait for income growth to slowly catch up with the elevated level of prices.