Former Finance Minister Lou Jiwei: The coming year will be a critical year to prevent financial crises, and both China and the United States are facing the risk of debt crises......

  Source |  China Real Estate Fund 100 Association 

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Guide

The risks of China's debt crisis are mainly due to the lack of demand for real estate, the liquidity difficulties of some real estate developers, and even the occurrence of debt defaults, and the hidden debts of local governments need to be gradually resolved.

A default on U.S. debt would severely weigh on the U.S. economy and could well trigger a global financial crisis. Although the national debt ceiling was raised through political compromise and there was no default on the US debt, it is expected that similar games will occur.

The year ahead will be a crucial year for the prevention of financial crises, and my overall view is cautiously optimistic. At the same time, it should be recognized that since crises are always unpredictable, and there are global spillovers, this requires the cooperation of all countries to prevent crises from occurring.

Lou Jiwei is a well-known economist and former minister of the Ministry of Finance of China

Five factors determine the "weak recovery"

Constrained by a series of negative factors, the global economy is currently in a state of weak recovery. These constraints are mainly in five areas:

First, since five years ago, anti-globalization has been rampant, and populism, nationalism, and protectionism have risen around the world.

The global industrial and supply chains are being restructured and no longer allocated according to the principle of comparative benefits, which is a loss of efficiency and is not conducive to economic recovery.

Second, the outbreak of the pandemic has suppressed the economies of all countries from both the supply and demand ends. Although the pandemic is no longer an international health event, the scarring effect of three years is severe.

Third, it has been more than a year and a half since the outbreak of the Russia-Ukraine conflict, which has caused a tight global energy and food supply and high prices, which has played a role in driving global inflation. Energy prices are gradually coming down, but it will take a while for core inflation to return to normal.

Fourth, since 2020, countries in Europe and the United States have adopted unprecedented expansionary fiscal and monetary policies to avoid a recession. But inflation is climbing fast. Since March 2022, the Federal Reserve and the European Central Bank have raised interest rates rapidly, and the inflation rate has gradually fallen, but it has also slowed down the process of economic recovery.

Fifth, in today's world, China-US relations are the most important bilateral relations. For a long time, China and the United States have been in competition and cooperation. Five years ago, there was a turning point in China-US relations, from competition and cooperation to competition and confrontation, which had an adverse impact on the global economic recovery. Recently, China and the United States have set up two working groups on economics and finance, hoping to establish an effective communication mechanism.

Solving China's economic problems requires a process

Some of these negative factors mentioned above are long-term structural and need to be resolved in a long-term cycle, while economic recovery mainly relies on countercyclical short- and medium-term adjustment policies. In the past year and a half, major developed countries have been in a dilemma between controlling high inflation and preventing economic recession by reducing the intensity of fiscal policy expansion and tightening monetary policy. So far, it has produced some results. Inflation has begun to fall and the economy is not in recession, but Europe is more likely to fall into recession due to structural weaknesses.

China's economic situation is different from that of developed countries. During the pandemic, China did not adopt the same aggressive fiscal policy as developed countries, and the intensity of monetary policy expansion was much smaller than that of developed countries. The economy is in a restorative phase this year, with an economic growth rate of 5.5% in the first half of the year. However, it is also facing new difficulties and challenges, mainly due to the lack of domestic demand, the operational difficulties of some enterprises, the many risks and hidden dangers in key areas, the complex and severe external environment, especially the lack of real estate investment and sales, and the need to gradually digest local hidden debts.

The economic recovery in the second quarter was less than expected, and the macro economy showed marginal improvement in July and August. At present, some measures have been taken, such as increasing liquidity support for real estate enterprises, reducing the interest burden of home buyers, resolving local hidden debts at the provincial level, and allocating a certain amount of replacement debt quota by the state to support, etc. These problems are accumulated over a certain period of time, and it takes a process to solve them.

Overall, I am cautiously optimistic about the prospects for the global economic recovery.

Will a new financial crisis come?

Will the global inflation and debt crisis trigger a new round of financial crisis? I will analyze this theme in two aspects. The first is the effectiveness of the financial regulatory framework. The second is the impact of high inflation on the financial crisis.

A relatively stable financial regulatory framework has been established:

Improvements in the financial regulatory system are often triggered by crises to prevent similar systemic risks from erupting again. However, the continuous evolution of the economic and financial ecology will inevitably lead to new crises and promote the further improvement of the financial regulatory system. It's a cyclical process of evolution and optimization. I will focus on the situation in China and the United States.

The United States has long pursued financial liberalism, and it is difficult to reach a consensus on strengthening financial regulation. At the beginning of this century, commercial banks securitized high-risk subprime loans without retaining any risk into the financial markets, superimposed various derivatives and leveraged, which eventually led to the 2008 financial crisis. At the same time, the systemic crisis led to consensus, and after more than a year of multiple rounds of compromise, the Dodd-Frank Act was passed, establishing a regulatory framework to protect the interests of taxpayers and consumers and prevent a recurrence of the financial crisis.

Unlike the United States, China is dominated by indirect finance, and financial assets are concentrated in commercial banks, but for a long time, interest rates have been regulated and capital market supervision is weak. After 2013, in order to obtain high profits, banks took assets and risks off the balance sheet through various methods, giving birth to various types of "shadow banks", which are actually "shadows of banks", and the financial assets launched are mainly "high-interest just exchange" products. There are more profound reasons for high real estate prices and the expansion of local hidden debt, but these "high-interest just cash" products have also played a role in fueling the fire.

At the end of 2015, the central government successively proposed economic deleveraging, preventing and resolving financial risks, and returning finance to its roots to serve the real economy, and maintaining the bottom line of preventing a systemic financial crisis. After that, the new asset management regulations came into effect in 2018. This is a regulatory framework jointly formulated by multiple regulatory authorities, which solves the problem of regulatory arbitrage due to uncoordinated supervision in the past. The new regulations require that the assets of banks must be withdrawn from wealth management assets, and the asset management departments set up by banks must be subsidiaries, isolated from commercial banking institutions, and risk isolated. Wealth management assets must be net-worth, and no new "high-interest just exchange" products are allowed. A three-year transition period is also provided for to prevent systemic risks from arising from risk mitigation.

In May this year, the State Administration of Financial Supervision and Administration was formally established to be responsible for the supervision of the financial industry except for the securities industry. While perfecting the financial regulatory framework, it has also expanded the reform and opening up of the financial industry, lifted the control over the interest rates of commercial banks, reformed the original listing examination and approval system in the stock market, and implemented a registration system on the basis of strengthening information disclosure. It can be said that China's relatively stable financial regulatory framework has been established.

Both China and the United States are at risk of a debt crisis

At present, countries around the world are tightening monetary policies to curb high inflation, which is likely to trigger the risk of financial crisis. A typical example is the bankruptcy of Silicon Valley Bank. Silicon Valley Bank's assets are mainly long-term securities, while the liability side is mainly short-term deposits. The Federal Reserve's continuous interest rate hikes have caused securities prices to fall sharply, and Silicon Valley Bank has incurred a large floating loss. Within 24 hours of the announcement, a run was formed, and Silicon Valley Bank declared bankruptcy, was taken over by the Federal Deposit Insurance Corporation, and protected all deposits, breaking the chain of contagion to small and medium-sized banks. This typical event has the following implications: First, curbing high inflation, especially rapid interest rate hikes, will trigger sharp changes in asset prices, which can easily trigger financial risks. Second, the digital economy and digital society have made the spread of risks faster than ever imagined in the past. Third, government departments must intervene quickly to prevent financial risk events from turning into financial crises.

In order to curb high inflation, developed countries have generally adopted a policy of raising interest rates rapidly. This leads to a rapid outflow of capital from fragile countries, creating a debt crisis. However, these countries have small economies and low global externalities, which are unlikely to trigger a global financial crisis. The U.S. debt crisis is the other extreme, and a default on U.S. debt will severely weigh on the U.S. economy and could potentially trigger a global financial crisis. Although the national debt ceiling was raised through political compromise and there was no default on the US debt, it is expected that similar games will occur.

China is also at risk of a debt crisis. The main reason is that the demand for real estate is insufficient, some real estate developers have difficulty in liquidity, and even default on debts, and the hidden debts of local governments need to be gradually resolved. As mentioned earlier, some measures have been taken, and the effects can be seen gradually. It is believed that further measures will be taken, and the balance sheets of large commercial banks are basically healthy. In any case, there needs to be a cycle to absorb debt risk, but there will be no global debt crisis.

The year ahead will be a crucial year for the prevention of financial crises, and my overall view is cautiously optimistic. At the same time, it should be recognized that since crises are always unpredictable, and there are global spillovers, this requires the cooperation of all countries to prevent crises from occurring.

(This article is a speech delivered by Mr. Lou Jiwei at the "New Space, New Momentum - Phoenix Bay Area Finance Forum 2023" on September 27-28)

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