¨ The increased spending is not paid for out of an increase in taxes but rather by borrowing. I think this is likely.
¨ There is no large reduction in private consumption, the government borrowing and investment does not crowd out private investment to any material extent, and there is no significant reduction in municipal government spending financed by real estate sales. Here I am much more skeptical, especially about the last two points.
¨ Disbursements begin rapidly and are not wasted.
¨ At least half of the global adjustment tales place outside China.
The success of this plan depends crucially on continued government credibility in the face of rapidly rising deficits (I predicted earlier this year that guessing the real size of the government liabilities would be a popular sport next year) as well as on the health and stability of the banking system.
If the banking system can withstand a downturn without any significant rise in NPLs and without forced credit contraction, this may be the shot in the arm China and the world needs, but there are very big question marks. Still, I think it is an indication of how worried the government is and how determined they are to address the issue that this plan was approved. (As a complete aside, I also think it is an implicit acceptance of Bernanke’s savings glut hypothesis.)
The discussion of the health and stability of the banking system leads easily into the second much-discussed option – really sort of a variation on the first. The government can force credit expansion by requiring the banks to lend more. Although there has been a process over the last decade of freeing the banks and allowing them more discretion in lending as a way of improving China’s dismal capital allocation process, there is no reason why policy-makers cannot reverse course and force banks to lend more.
Certainly they are trying. Last week, after weeks of rumors that loan caps were being relaxed, the PBoC announced that they were junking the credit restrictions they had previously imposed on banks (interestingly enough they have always denied that they had imposed constraints). But instead of gleefully exploiting their newfound liberty banks have refused to party, and loan growth has been very low.
This is hardly surprising. In such dire economic circumstances with global credit markets and liquidity seizing up, with domestic bankruptcies rising, with inventories and receivables also rising, it takes both brave banks and brave borrowers to accommodate credit expansion. Most good companies seem reluctant to borrow and anyway banks are reluctant to lend.
So what if policy-makers simply announce minimum loan growth targets for every bank? That should certainly cause an expansion in banks’ balance sheets.
I think, however, that there are two problems with such a policy (although administrative measures of this sort hold a dangerous allure to policy makers). First, I don’t think it will be effective in net credit creation for the country. This argument is simply the flip side of my previous arguments as to why I did not believe the loan caps that were in place until this summer actually restricted credit creation.
In those days I argued that if monetary conditions are consistent with rapid credit creation, we will see credit creation. Any attempts to restrict credit creation will simply meet with some or all of the following responses:
1. Banks will innovate around the restrictions.
2. Credit creation will occur outside the restricted areas.
3. Banks will lie.
In China’s case we have definitely seen innovation (securitizations and transactions that took loans off the balance sheets of banks) and outside growth (rapid increases in dollar loans and policy bank loans and, most importantly, growth in the informal banking sector). If there is a sharp contraction we will know if there have also been many cases of lying.
The same thing can happen in reverse. If banks don’t want to lend but are forced to, we will see off-balance sheet transactions placed back on balance sheet and a much more rapid decline in loans from informal banks. That means that real credit expansion can still be negative even with minimum loan growth target enforced onto the banking system.
The second problem is likely to be the quality of the loans. It is always possible to find borrowers, even in a sharp economic contraction and an overinvestment crisis. The problem is that many of these borrowers are not the ones that any prudent bank should be dealing with, and to the extent that the forced loan expansion is successful, it will probably do little more than ease the credit crisis in the immediate near term and make it much worse in the medium term.
A variation of this might have happened in Japan in the 1980s. As Japanese GDP growth slowed from its very high levels in the 1970s (from an average of roughly 10% to an average of roughly 6%), Japanese banks flush with liquidity were eager to extend loans. Loan growth actually accelerated steadily from around 7% in 1980 to around 14% in 1987, even as GDP growth declined from around 8% in 1980 to around 5% in 1987. Credit creation vastly exceeded real credit needs during this whole period, with the balance going largely into real estte lending and, later, stock market speculation.
We may have already seen this process in China in the last four years and of course I don’t want to suggest that the processes in China and Japan are identical, but I do want to point out that forcing credit expansion beyond the real needs of the economy can create tremendous future problems, and China may have already gone through this very process with a monetary policy that accommodated too-rapid credit growth (much of which may have occurred, of course, outside the banking system).
