China’s policy challenges

Unsurprisingly Chinese Premier Wen Jiabao has confirmed that some policy “fine-tuning” will be necessary this quarter in response to recent economic developments. Although he did not specify what types of policy adjustments were being contemplated, it would be remarkable if lower bank reserve requirements were not one of them. Also, there is plenty of scope to ease fiscal policy, through targeted tax cuts and spending increases. Finally, during this more challenging period we are more likely to see the exchange rate remain relatively stable. Interestingly, Wen reiterated a message which other policy officials have made recently, namely that restrictions on real estate will not be altered, as Beijing attempts to make housing generally more affordable.

Interestingly, the FT reported this morning that banks had been instructed to roll over loans made to local governments because in many instances the principal could not be repaid upon maturity. In order to prevent defaults and provisions, banks have been forced to extend loans, in some cases by as much as four years. Last June, the National Audit Office in China reported that loans to local authorities totalled CNY 10.7trln at the end of 2010, or around USD 1.7trln (roughly the size of the Canadian economy). According to S&P, close to one-third of these loans have already, or will, turn toxic in the next three years. To put this in to perspective, bad loans to local government alone could equate to USD 500bn, or around 8% of GDP. This is a very big number. China cannot hope to realistically open its capital account (as a prelude to currency-convertibility) until this huge issue has been resolved.