The slowdown in global growth and weakness in commodity prices have pressured the Chinese economy. The country relied on massive government and private sector borrowing to finance infrastructure, and the weak economy means an increasing debt burden. In the first quarter of 2016, gross domestic product (GDP) growth slowed to 6.7%, its weakest level since 2009. Meanwhile, the country continues to grow its money supply and extend credit. The official money supply increased in 2015 by 16 trillion yuan. However, a new report by Goldman Sachs Group Inc. (NYSE: GS) suggests that the money supply grew by an even greater amount than official estimates.
Goldman Sachs' report has ramifications for both Chinese policymakers and global markets. As the country manages the twin problems of slow growth and mounting debt, it must coordinate its actions with other countries and engineer a soft landing for its economy. In essence, China's problems are inextricably linked to decisions made by Western economies, such as the United States.
Measuring Credit Creation
Analysts rely on an official number called total social financing (TSF) to measure total credit creation in the Chinese economy. The statistic, which Chinese authorities created in 2011, ostensibly captures credit creation by the country's shadow banking system better than the official money supply. However, in June 2016, Goldman suggested that this figure understates actual credit creation. Specifically, Goldman found that TSF fails to account for bank lending to nonbank financial institutions. Such lending is part of the convoluted system of financing in the country where institutions lend to other institutions, but the money may never reach the real economy. In other words, total indebtedness may increase without economic benefits. The surge in investment assets and claim on bank balance sheets may presage the increase in overall indebtedness.
Goldman believes that a better way to capture credit creation is to measure the money flow from households and companies into financial investments. Using Goldman's measurement, actual credit creation registered 24.6 trillion yuan in 2015, which outpaces the 16 trillion yuan increase in the money supply and 19 trillion yuan increase in TSF. The Goldman money flow measure equates to 36% of China's official GDP in 2015, and represents a 58% increase over the 2014 figure. Goldman believes the disparity between actual credit creation and official measurements highlights the lack of transparency about credit in the Chinese economy.
A Policy Shift
The fact that overall indebtedness is increasing while growth remains stagnant may lead to a change in thinking from Chinese policymakers. While Chinese policy has been focused on keeping the yuan strong to bolster its domestic economy, some economists and analysts believe that a weaker currency is inevitable. In March 2016, several prominent bankers and economists lobbied the People's Bank of China (PBOC) to devalue the yuan. One explanation is that China wants to bolster its export economy to offset slack in internal demand. However, a more plausible explanation is that gradual devaluation enables China to keep its currency in line with its regional trading partners. Ultimately, China must not allow the currency to weaken too much or it risks even more capital outflows, which could further weaken the economy.
Coordination With Global Central Banks
China seeks to maintain a delicate balance with its currency. On one hand, it desires a weak yuan to aid its export economy. This goal is important given the headwinds of weak commodity prices and anemic global demand. On the other hand, the country wants a strong yuan to maintain foreign investments and prevent further capital outflows. To achieve this balance, China must, at the very least, monitor the activities of central banks, such as the Federal Reserve Bank (Fed), and perhaps coordinate its actions with them. Since China pegs the yuan to the dollar, Fed actions impact its exchange rate. In May 2016, Chinese officials sought a meeting with Fed officials to discuss the Fed's plans for future rate increases. Given China's fragile economy, it seems increasingly likely that such meetings may occur more regularly.
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