BOFIT Viikkokatsaus / BOFIT Weekly 2016/34

In its annual Article IV consultation, IMF staff recognises China’s advances in shifting to a growth model increasingly driven by consumption and its progress in certain areas of structural reform. Nevertheless, the report puts emphasis on of increasing economic vulnerabilities and a distinct lack of progress in many critical reforms. In particular, soft budget constraints on state-owned enterprises (SOEs) means cheap money gets channelled to inefficient projects and corporate indebtedness balloons. The ability of firms to service existing debt burdens has faltered with the declining profitability of industrial firms. This includes a growing group of firms with insufficient profits to cover even loan interest.

As firms have piled on debt, financial sector has swelled in size and the links between banks and nonbanks have expanded rapidly. Growth of the shadow banking sector and development of novel financial instruments has made the sector opaque and officials overseeing it find risk assessment increasingly difficult. Moreover, interconnections of the sector increase the risk of spill-overs, which will fuel further problems.

As corporate indebtedness continues to rise, the likelihood of the emergence of disruptive adjustment keeps growing, which could lead to banking crisis and cause a rapid slowdown in economic growth as has happened elsewhere in similar circumstances. For this reason, the IMF hopes for decisive action from China to reduce the vulnerabilities, even if it means lower growth in the near term. SOE indebtedness must be curbed, heavily indebted firms must be restructured or liquidated, and losses need to be recognized and shared among firms, banks and creditors. The state should also be prepared to participate in clean-up costs and help find work for the displaced and make it easier to start new firms. The financial sector should also be better prepared to take such measures as bolstering bank asset buffers, writing down bad loans as credit losses and reducing risks associated with the shadow banking sector. Officials need to intensify their supervision efforts and get crisis management plans in place.