 Okay. Good morning, everyone. My name's Chris Johnson. I'm the Freeman Chair in China Studies here at CSIS. And I want to thank you all for coming to our inaugural China Reality Check event for 2014. Meant to have it a week ago, but the weather got in the way, so we thank everyone for their flexibility in terms of the change in time. I'm very, very pleased to be holding this event today. When I wanted to go back and look at the original language that I used when we put out the idea of having this China Reality Check series as a concept. And I talked about the purpose being things that will sort of seek to step back and take a more in-depth look at China themes that are controversial, poorly understood, or that in our judgments simply have not received sufficient attention here in Washington. And I think it's very fair to say that this issue takes all three of those boxes. Certainly controversial, certainly poorly understood, and at least in my own assessment doesn't get enough attention around this town given the gravity of the issue. And I don't think we could possibly have two finer speakers on the subject. I'm really pleased to have both Nick and Derek here. Their bios are in the pamphlet that you should have received when you walked in, so I think we'll get right into the substance. What we're going to do is we'll have each of them kind of present their own view on how they see the issue, and then we'll engage in a dialogue both amongst ourselves and with you to kind of tease out whatever we can in terms of meaning here. So without further ado, Nick, would you like to start off? Thank you, Chris. Just make sure it's on there. Okay. Thank you, Chris. I think it is an important subject. I think there are a lot of murky things about local government debt in China. I think there's some uncertainties. I'm not going to talk so much about the magnitude of local government debt because we've had a ton of coverage of that in the financial press since the National Audit Office released its survey. I think everybody knows the number, 17 trillion RMB, which can be disaggregated into various categories. My view is that we should pay less attention to the magnitude of the debt and more to the sustainability of it, and particularly to how is the money being spent. So there's a lot of discussion about how big it is and how rapidly it's been growing and not enough focus on what the money is actually being spent on. The audit has some detail on this that I think is quite interesting. They give us pretty good detail on about 10 trillion in expenditures, finance. This is the stuff that's been financed would be explicit, not the contingency and you might have to pay it. And if you look at that list, municipal construction is about 3.8 trillion, which is almost 40% of the total. Transportation communication is another 1.4 trillion, which is 14% of the expenditures. Public housing gets a little bit about 7%. There's a little bit for science, education, public health, a little bit on water, agricultural water projects, a little bit on environment. Then there's another fairly big chunk, about 17% on land. I'm not quite sure how to interpret that. But my view is that the great bulk of this expenditure looks like it will have high economic returns. China needs more urban infrastructure. I think people would think China has over invested in, particularly in transportation, you know, should try to move around Beijing and Shanghai more frequently. So I think, you know, maybe they've built ahead in a few areas. Certainly a few white elephants undoubtedly have been built. But on balance, I think that a lot of the expenditure, the bulk of the expenditure has gone to projects that will have high economic returns. Now, the problem in many cases, of course, is that the financial returns from these projects are extremely low and will not be sufficient to pay off the debt. And I think that's been clear from the, from the outset, and that's why a lot of people worried about local government debt. You just take municipal metro system subways. The Fairbox barely covers the operating expenditure, just as the metro system in Washington, the capital expenditures have to come from somewhere else. And they have, in the short run, in the, in the crisis of 2008, 2009, decided to finance these with short-term bank debt, which maybe wasn't a very good decision. But I think metro systems will have positive economic returns. They should be subsidized. The fair should not be the full cost. How many people would ride the metro here if the fairs were four or five times what they are today, which is what it would take to cover the full cost of the operation? It's a public good, and it should be subsidized. Everybody benefits when more people go on the subway. There's less congestion, there's less pollution. And since it is a public good, a subsidy is appropriate. You can argue about what the magnitude is, of course, but the fact that the subway system is not going to make enough money to repay the financing does not mean it was a mistake. And I think a lot of the investments fall into this category. Certainly, there's plenty of evidence that most municipal water systems and sewage treatment systems lose money. China is moving to raise those fees for those services, so maybe eventually they could be more self-financing. But in the short run, they're not. So that's, I think we need more attention on the expenditure side. I think the audit gives us kind of a little bit of detail about what it's been spent on. But I think we need a lot more detailed understanding of exactly where the expenditures have gone. Maybe when that, if and when that's available, I might have to modify my relatively optimistic view. But for the moment, I'm relatively optimistic. Now, the second thing that I think needs more attention beyond the magnitude is the sustainability of the debt. And here there are several things to keep in mind. First of all, this is totally domestic debt. It's all in domestic currency. We don't have any currency mismatch issues, which has been a problem in, you know, in the Asian financial crisis and other financial crises. The other second thing to keep in mind is that the real cost of financing the debt is much less than the growth of nominal GDP. The single most important metric to look at, if you want to know whether or not debt is sustainable. And of course, the sign that it's not sustainable means that the debt to GDP ratio is rising continuously. But if the interest rate you're paying on the debt is less than the growth of nominal GDP, that ratio doesn't necessarily rise. UBS has estimated that the weighted average cost of local debt is a little bit more than 7%, about 7.3%, which seems a reasonable number given what we know about interest rates that prevail in different kinds of financing operations. GDP growth, nominal GDP growth last year was 9.5%. Everyone looks at the 7 point, whatever it was for real, but the nominal is the number that matters here. So nominal GDP is growing at almost 10%. So basically there's more than a 2% point difference between the rate of growth of nominal GDP and the financing cost of local debt, which implies that problems of sustainability are not necessarily as acute as some people think. I think it is true that the pace of accumulation of this debt needs to slow down. But I don't think we're in a sustainability problem at the moment. Debt will have to be rolled over. That was acknowledged by the government. I can't remember exactly when a week or 10 days ago. In addition to the problem that a lot of these projects don't generate much financial return, even though their economic returns may be high, the maturity structure is relatively on the short term, given the nature of the projects that are being financed. So there will have to be, there will have to be rollovers. I'd just say maybe a couple more things to put things in perspective before turning it over to Derrick. First, we have to keep in mind China is not a federal fiscal system. It is a unitary fiscal system. Local, when you hear the government report from the Minister of Finance when he appears at the National People's Congress next in March, they give you a consolidated government budget. This is not a system where every locality is on its own bottom. There's a lot of transfers going on back and forth across geographies and across levels of administration. And at the end of the day, there will certainly be a big fight that I have no doubt that when push comes to shove, the central government is going to have to assume the responsibility for repaying some of this debt. That's the way the system works. It will be fought. Everyone will want someone else to pay, but it is not a federal fiscal system, so the outcome is likely to be something along the lines that I suggested. Second thing to put things in perspective is yes, local, if you take the sum of central post local debt, it has gone up around 45% of GDP in 2010 to about 54% at the end of 2012. But China does not look like an outlier compared to most other emerging markets. If you take the sum of central and local debt in Brazil, it's 52%. India 71%, Turkey 54%. Well, you're not reading the Financial Times three times a week talking about the problems of local government debt in those countries. China has gotten a lot of attention, and I think a lot of people have the impression that China is a big outlier. But if you take the sum of central and local government debt across these systems, China at 54% is certainly way below India and almost identical with Brazil and Turkey. The last point I would make is just to remind us that we shouldn't always be thinking of gross debt. We always read the numbers on gross debt, 17 point, whatever it is, trillion. We also need to consider the asset side of the state balance sheet. The Ministry of Finance data suggests that state enterprise assets are about $91 trillion at the end of 2013. That's about 163% of GDP. China is a bit of an outlier in that the assets control, this is only enterprise assets, so this is not counting the value of schools and hospitals and government buildings and things like that. These are enterprise assets, the Tia. If we want to look at the overall situation, I think at least we should acknowledge from time to time that we're looking at the gross numbers and that state assets far exceed by a factor of at least roughly twice. State assets are roughly twice as large as liabilities. I think the pace of growth of this debt should slow down, but I think the probability that it's going to create a financial crisis is relatively low. Good. Okay. Thanks, Nick. In a shocking development, I am much more negative than Nick is. I'm sure all of you will be stunned by that. That's good because then we'll have more of a discussion. I don't think if you take local government debt in isolation that it is a serious problem. So in that sense, I'm quite in agreement with Nick. I think it is if you tie it to what it's directly connected to, which is corporate debt and banking debt, then you have a much bigger problem. And I think it is symptomatic of a development model that is failing. And so I don't I'm not looking for a crisis. There's going to be an acute crisis. And then, you know, we're hearing all this talk about defaults on a trust product, which I think would be a good thing. I don't I don't see any sort of acute financial crisis arising out of local government debt, or even a larger debt problem. But I think China is looking squarely in the face of stagnation on local government debt as a key symptom of that. So I will start as I always do talking about how I think the numbers are wrong. That cuts both ways. It doesn't always you know, the numbers being wrong doesn't always mean China is in worse shape than it represents. Finance moves faster than regulators do. It also moves faster than statistical authorities. They're, you know, we have illustrations of this here, you regulate one type of product, they create a new type of product, which you aren't counting. And that China has had that problem repeatedly. It's not just China. Let's be clear, we're talking about China here, but China's had that problem repeatedly with local government debt. So in the 2010 audit, local government financial vehicles were said to hold about $5 trillion of local debt out of the total of more than 10 trillion. But this didn't include debt that was implicitly guaranteed or backed by state collateral. So they chose a very narrow definition of local government debt. Some estimates at the time said that when you included it, you got 13 trillion won as the debt number, so more than double. What is a lot of what has happened now in the increase from the 2010 audit to the 2013 audit is that they're just counting differently. It's not new debt that's been accumulated in the interim. It's a different definition of debt. So, you know, that again, that cuts both ways. And specifically, there's been a lot more accumulation by local SOEs, state and enterprise, which is something I'm going to talk back on behalf of local governments, related to that there are entrusted loans, loans from one company to another that's supposed to be backed by a bank, but sometimes aren't. And they've also created this category of IOUs for goods and services, all of which were undercounted in 2010. In 2000, I'll give you another illustration. In 2010, banks accounted for about 80% of lending. In between 2010 and 2013, they supposedly counted for less than 25%. So they're 80% of the lending up to 2010. They're 25% of the lending between 2010 and 2013. That's not actually what happened. They just counted different things that didn't count the first time. It's not that banks dropped off the face of the earth as financiers of local government debt. They did the definition change. I want to give more examples of this because it's important for people to know that you've got to be careful looking at the numbers that are being represented and also the interpretation in the Western press. Shadow lending was not mentioned in a 2010 audit. Now we can't swing a debt. Sorry, I shouldn't say that. You can't take a step without hearing about shadow lending being a problem in China. It wasn't even mentioned in 2010. The NBS had no entrusted loans, firm to firms, because firm to firm lending was illegal before 2006. It's just not true. So I'm giving you examples of where, I mean, just blatantly not true. They just decided not to count this because it was illegal. So why am I giving these sorts of examples? The worst case is that all these numbers are wrong. Just they're all wrong. Can't trust any of them. But the best case is it really isn't a 70% increase in local government debt in two and a half years. The best case is, all right, we don't know exactly what the numbers are, but they were higher than they then stayed in 2010. They certainly were higher. And what we've got now is maybe they're catching up, which is not to say there hasn't been growth in local government debt. And it's also not to say that the number you're getting now, the 17 plus trillion one is correct. What I would put the characterization on if I had to sum this up, and I have much more data here of examples of why you can't trust these numbers, is that the debt is higher than they say it is higher than 17.9. I can't remember the exact figure trillion one. But the growth rate is considerably less. And so one of the things I would look at in response to Nick's concern about the rate of debt accumulations, I don't think the rate of debt accumulation is actually that high. It's high. It's bad. And I think the problem is larger than it appears, but a lot of the increase has been just counting things differently. And that's what happens. Statistical authorities don't keep up with what's actually being used in the financial industry to accumulate debt. That is an ongoing problem. It isn't solved now. It doesn't mean all the numbers now are right. That's not what I'm saying. I'm saying that I'm hoping they're catching up and the discrepancy between reality and the official figure is smaller. Point one. Point two. And Nick may push back on this or some of you guys may and I would love to because this I have this written down in my notes is there's a magic trick. I mean let's not forget that this is either a little or a lot strange. Local governments either always want to borrow more money or they were ordered to in 2008 2009 by the central government in the stimulus program. While being ordered to or because they always want to they can't legally run up large budget deficits or sell bonds except in very small and exceptional circumstances. So they set up local government financial vehicles and local government financial vehicles borrow from banks in very huge amounts through 2010 and then from some other vehicles as well after that. Some of the banks are borrowing from sometimes most of what they're borrowing is from local banks which are state owned. Let's think about that for a second. The entity set up by the local government to borrow is borrowing from another entity previously set up by the local government. When it's not done by local governments it's often done by local state owned enterprises. So it's a local non financial entity borrowing from a local financial entity all owned by the same people. When it's done by national banks it's a local locally state owned financial entity borrowing from a nationally state owned financial entity. It is very difficult to think of these seriously as transactions between different parties and we forget that. Who are they borrowing from and this is this is a I don't mean to put these words in Nick's mouth. This is a strong extension of Nick's point about risk. I mean you know what's the risk. There's almost no counterparty risk in this debt at all. It's almost all owed to parties that are controlled by the same entity. So when we think of you know one of the things I hate most is that the local government debt crisis reminds me of Layman. As soon as you hear that from someone just turn them off. Just don't listen to anything more that they say. I mean what's Layman. Layman is I can't trust you. I don't know the value of your assets anymore and you get a credit market freeze. That's you don't do that in China. You don't say to your sister entity owned by the same people run by the same people responsible to local party countries. I'm not doing business with you anymore. You don't have that option. Just like banks didn't have that option in 2008-2009 to lend less when profit margins were dropping because of weaker demand. So I just you know the nature of the risk here is to my mind less. It's stranger. It's not an acute risk. So that's that's number two. You know number one is I think that the debt is larger and but growing small slower than reported. And number two let's not forget that these are related parties. Sometimes very very strongly related parties like the same person lending who's operating both entities. All right let me set this in context quickly. I don't want to take up too much time because I'd rather have a discussion. The local government debt estimate of 17 point whatever it was it was mid-2013. At the same time the pay people's bank put total debt at about 115 trillion rem in B. It's not clear that those are compatible numbers because I think there's an overlap and they're counting differently. But that puts local government debt at about 16% of the total again. If somebody told me it was 12% or 20% I'd say okay fine. But that's the range we're talking about. We know bank lending from from 2007 the end of 2007 to the end to to 2013 and 2013 increased 175% 45 trillion rem in B. 18 percent annual growth. And we know most of that was counter cyclical was after the layman shock so loan quality should be less than it was before. We know there are ongoing purges of bad loans from bank books that hasn't stopped. We know there are sales of subordinated debt to other banks which is a shell game. The SOE's that borrow on behalf of local governments we know something about that. CAS had local CAS I'm using a higher total well let's just use the regular rule. Local government debt at 17 plus trillion rem in B. CAS puts non-financial enterprise debt at almost 59 trillion rem in B. So again this is a much bigger debt problem than local government debt. I'm giving you some illustrations. It's hard to do this without flooding people with numbers. Chinese non-financial in the last Fortune 500 their debt ratios debt asset ratios are much higher than the U.S. entrance in the same in the same group. CAS says that puts the debt asset ratio as the highest among government of Chinese corporates highest among 20 countries surveyed. Bank of International Sessionals said it says it's well above what they consider to be the danger point. So local government debt is miscounted it's probably changing differently. There's a little bit of a game going on here. I don't think there's an acute risk but I think it ties to because remember banks and state and enterprises and I've just been quoting bank and state and enterprise debt are intimately connected with local government that there are much bigger debt problems in China and local government debt is a recently interesting or interesting in the Chinese sense may you live in interesting times is a recent manifestation of an ongoing debt problem and the ongoing debt problem has gotten worse in every facet since the since the 2008 stimulus. So let me think about let me talk about policy for a second. I think it would be better ICBC and the government had just said to the people who had held wealth management products from this this entity that was back in the coal company fine you're out of luck. I think they're going to be sorry to the extent of any how any intervention comes out. I think even the perception that there's intervention is a mistake. You know I think this encourages the scheme where people think that they're getting unsustainably high returns. I think it's actually happening with Alibaba now where they're drawing they're drawing clients away from regular banking by offering unsustainable high returns and claiming it's all efficiency gains on their part which I find very difficult to believe. So I wish we would see some defaults. When you see defaults this year if we have them that's healthy. Obviously thousands of defaults in a three-day period would not be healthy but the occasional default and maybe even an increasing set of defaults where you have a default as a warning and then you have more would in fact be healthy. The system needs some defaults. Sometimes financial entities go bankrupt and when they don't go bankrupt they're just being kept up and unsustainable loan borrowing patterns being kept up. Now a real policy solution which the Chinese are talking about would be a very I don't want to say rapid but a very considerable expansion of the role of the bond market. Right now the bond market is dominated by interbank bonds which are in turn dominated by state financials but the bond market access to the bond market can can be improved much more quickly than the other side of this which is privatization and banking. Now the Bank Regulatory Commission says they're going to set up three to five private banks this year even if they're successful the additional private assets held in the banking system it's going to be trivial compared to the existing state assets. This is not going to change the nature of the banking system for many years to come whereas the bond market can change the nature of the whole financial system a lot more quickly. All right and I don't want to again as I said I don't want to take too long I have many many remarks to make along these lines. It looks to me like they are on the policy side that there's a lot of paralysis here and I think you see that even in statements from the central government. On the one hand on the other hand you know economists are supposed to say that but policy makers aren't. They see the problem there's no question there's no I don't think that we're in denial the way perhaps some people were 2008 2009 but they're afraid to act decisively and this is not just a political problem we have political problems on decisive action and entitlements. Everybody in the country thinks we need to curb entitlements and then no one does it for political reasons. I think in China there's an actual economic problem. They want to change their model but they don't want to do it too quickly and the more slowly they do it the more they're accumulating debt of all kinds again I agree with nick about local government debt accumulation not being that dangerous but I think the corporate side is quite dangerous. So it's all the same entity I'm wrapping up one an acute crisis is unlikely because there's there's no counterpart or very little counterparty risk but the policy hesitation here just shouts out to me stagnation and I want to point out to you that even if you're bullish on reform which I am not at the current time I didn't find the announcements in November to be very reassuring much less the implementation but even if you're bullish on reform something I say in a paper that's coming out you know market economies aren't immune from stagnation obviously they're not immune from financial crisis is very sorts so reform turning China into market economy it's something that needs to be done it's something that will help in the long term it doesn't necessarily solve the financial problem just you know just think about an incredibly successful reform where we all consider China to be deserving of market economy status and then I'll name to you all the market economy financial crisis that occur so you know what we need to respond properly to this is not a sense of panic there's going to be a meltdown in 2014 there isn't the counterparty risk for that we need very targeted reforms at the financial system which in my opinion would be led by the bond market not the banking system thanks. Good thanks Derek Nick I want to give you a chance to kind of respond to that I guess the issues that I heard that I'd be curious about your view because you didn't address them in your opening remarks this idea of the definitional problem you know how how debt is defined and how that works maybe speak to your view on the the shell game if you will among handing debt from from one entity to the other and then just your thoughts on the bond market and anything else you want to address well I certainly agree with Derek that this most recent audit of local debt is on a on a different basis than the earlier one I think it's a big improvement because it it went down one level instead of three levels down went four levels down went down to the township level that added on I guess 375 billion rmb something like that not a huge amount so it went deeper and it covered a range of things that were not covered in the 2010 audit so I think it's a it's an improvement in that respect it does make it hard to make direct comparisons with the earlier audit you have to take specific items that are more comparable but you can't compare the aggregate number today with the aggregate number in 2010 it's not apples to apples but I think they should be commended for expanding their the definitions both in terms of the the nature of the liabilities that they included and also going to the fourth level and you know on this there's no risk because every it's all state entities lending to other state entities obviously there's a a big element of truth to that and I agree very much with the spirit of Derek's remarks is what what we need is some defaults instead of papering every every risky transaction over or the government intervening this is what China needs more than anything else to establish a a sounder financial market so people pay attention to risk everyone is buying assets now based on what the advertised rate of return is and they're not looking at it on a risk-adjusted basis or maybe they are looking on a risk-adjusted basis there's no risk because there's never been a default so you know the only thing you need to do when you are investing your money is you shop around until you find the highest return and that's not likely to lead to a very good a very good outcome in the long run so I certainly agree that there has to be a greater sense of risk maybe we're edging toward it in this coal trust company product that has gotten a lot of attention in the last week because at least ICBC is sticking to its guns that it's not going to bail out investors the money is going to have to come from somewhere else so even though ICBC may have been the the distributor the channel through which the fund was made available to investors they're making it very clear that they don't stand behind the product so I think that's a step in the right direction I do think that I don't go all the way with Derrick on this because they're all state entities there's no risk involved I do think that banks look more carefully at who they're lending to they're lending a lot more money to the private sector than to state companies these days in part because the private sector has much higher rate of return on assets than state companies do and you can see what's happened as a result the growth of assets for non-state companies now is much much more rapid over the last decade than for state companies the share of overall investment the share of fixed asset investment that state companies account for was 90 some percent when reform began now it's under 40 percent and excuse me under 40 percent private companies account for a much higher share of fixed asset investment than state companies do so I do think there's beginning to be the beginning or some progress in creating a credit culture in the banking system and banks are lending on a on a sounder basis than they have in the past of course that's a that's a pretty low bar yeah I'll just take Nick's last point and and this could turn into a much sharper disagreement between me and him but it wouldn't be on local government debt you know I want to say I said counterparty risks not system risk there's clearly system risks that's increasing with these practices and would be reduced in defaults I just don't take the counterparty risk seriously like ICBC is going to be mad at a a state-owned coal company it'll be settled through the party not through the financial system so there's a political risk there's a system financial risk this is not a counterparty risk which is what froze us credit markets in 2008 I think one place which might be interesting to talk about where Nick and I sharply disagree and I don't know how related this is is this role of the state in the economy I certainly agree that if you go back far enough the role of the state in the economy has decreased but I think a lot of the appearance of change in the role of the state is they're shifting not to the private sector but to what China accurately calls the non-state sector which means that these are these are hybrid entities and if you look at state statistical bureau figures for the investment Nick has it right on SOEs it's now explicitly SOEs it's 40 percent below 40 percent but the domestic private sector what they say private this is private is 20 percent and everything else is something else and I do think if we want to bring this back to the debt situation in the local government debt case it's state owned enterprises that are doing the substitute borrowing for local government financial vehicles so I don't know that I think the non-state role in much less the private role in the local government debt case is very large I think when those corporate numbers I gave those are aggregate corporate numbers those Fortune 500 numbers skewed toward SOEs but the CAS and the Bank of International Settlements numbers CAS is Chinese Academy of Social Sciences sorry CAS and Bank of International Settlements numbers are aggregate corporate numbers and so you know some of that is going to be state some of that's going to be private and some of that's going to be mixed and we have this idea that well as local government debt is all backed by the government probably state owned enterprise debt has to be backed by the government private debt is not backed by the government what about these mixed categories I mean you know not wholly state owned limited liability corporations that's the term well not wholly state owned limited liability corporation can be a majority state owned limited liability corporation or a state controlled limited liability corporation now that would be an interesting part of the corporate debt picture maybe a crucial part of the corporate debt picture because that might be the pivot where the government has enough resources that state owned enterprise debt is credible but these mixed these mixed entities as you know the backing is not credible on the local government side you know these are all state entities which is why I emphasize the sort of magic trick part of this it doesn't mean that there isn't systemic risk it's just hard for me to take seriously you know when we when we talk about that ICBC product there are there's a a quasi private entity involved local government debt is just a local government financial vehicle buying from a state bank and to me that's all a sovereign issue and as Nick said at the beginning it's denominated local currency you can spend your way out of it I just you know spend your way out of it meaning print money out of it the the threat from that is not a crisis the threat from that is why are you incurring this debt you're incurring this debt because your reforms your your discrete economic policies are not generating enough wealth and and so when you have to incur debt and debt and debt to try to maintain the pace maintain the pace of economic activity as measure by GDP you have an unsustainable model so again on a local government you know there there may be real risk that the real risk there may be the kind of risk that that Nick is talking about on the corporate side with these mixed entities local government debt side I don't see any acute problem I see a symptom a symptomatic of a failed development model I'd like to just sort of look at a couple different issues one I'd be curious to hear your guys' view on how you know we have all the reform proposals that were rolled out at the plenum how do you see the local debt problem sort of interconnected with all those other reform areas you know that they're considering doing them it strikes me that in those three or four main categories financial sector reform dealing with this issue and so on they're all kind of interwoven and how do you see in terms of the prioritization that the government seems to be putting its weight on coming out of the plenum and after the financial and economic work group meeting how do you see them looking at that in terms of where local debt fits and the priorities and how it relates to their ability to make progress on those other reforms well let's say a couple things I don't think there's any doubt that the central authorities want to slow down the pace of accumulation of local government debt and as Derek has already said to some extent they've accomplished that to some extent they've accomplished it in the aggregate to some extent they've pushed it into different financing channels so it's a complicated mixed picture I think the most important thing coming out of the the plenum is the tendency for interest rates to rise I think we've been in an ultra low interest rate environment in China since 2003 that has led corporates both private and public to take on more debt probably than they should have lots of projects you know the real average lending rate over the last decade has been in the neighborhood of three percent lots of projects look very profitable if you can borrow money for three percent the central bank over the last year has been nudging rates up you see it in the interbank market that's one of the central reform initiatives that's in the the plenum documents and I think you know the central bank's getting a good start you see it in the interbank market rates are going up government paper rates are going up everything's going up so this is the challenge how do you move from an environment where your growth has been generated by very high levels investment funded with cheap credit to an environment where you have higher cost of capital less investment more concern about what the rate of return on assets is can you get the reallocation of credit into more productive sectors fast enough that you can sustain a reasonable rate of growth even with a much lower rate of investment I think that's what they need to do but it will be a challenge and I think that's what the central bank is taking the first steps on I agree with most of that I think try to make one general comment and one specific comment there's a very tempting the Chinese can solve the local government debt problem by just handing out orders and shifting the pattern of debt accumulation away from local government financial vehicles they've already started to do that as Nick said I think they can continue to do that that's not really a solution it's very tempting you can simply announce that the growth rate of local government debt on a comprehensive measurement which we are now adopting to show how transparent we are has sharply declined and they'll be able to do that but if you don't engage in comprehensive financial reform all you're doing is going to shift the borrowing to entities that are related to a local government and politically as we know very well in this country if I can define and isolate a problem and solve it this other stuff that's going on over there I don't want to hear about that so it's very tempting for the party to isolate the local government problem and say local government debt problem and say I've solved it that's not what they need to do they need quite comprehensive financial reform which is much harder but will actually address their problems and that's the political what do I want to say seduction there that there's an easy thing that does look like a solution and you can represent it as a solution then it's not and I think Nick's citation of 2003 is wonderful because that's when I started screening that the Chinese economy was getting weaker rather than stronger this is a 10-year problem we're talking about you don't solve 10-year problems in a year or two this is another political fallacy I'm going to take this dramatic action and now the problem is solved we should expect and I wrote about this early last year we should expect these signs of stress in the Chinese financial system to last four years they're not bad they don't indicate a problem they indicate that maybe someone's trying to solve the problem they might indicate that no one's trying to solve the problem but they could equally well indicate that people's bank as Nick said is acting in a way to address the problem so if you see an interest rate spike thank goodness we're getting interest rate spikes instead of the junk we've had to now so you know people have become oh this we've had you know months and months now of stress in the financial system we're going to have years of stress in the financial system we're either going to have it because the financial system is getting weaker or hopefully because the government is taking action which is risky and difficult to make the financial system stronger so stress in the financial system does not tell you that there's a problem there's going to be a problem anyway which is 10 years of bad policy is going to give you now again I'll come back to the to the bond market that is to me the way to shift the burden off of traditional lending where you know too much of the burden has been placed now the burden has switched shift off from state banks to other kinds of banks but it's still a banking burden rather than a bond market burden and you can see here again the problem for the government if you diversify finance away from from the banking system it has a whole host of economic benefits but it also means your lever of control over the economy is weaker and what were they able to do in 2008-2009 it wasn't the fiscal stimulus they announced in November that didn't mean anything what mattered was 30 plus increase in bank lending in a in a weakening environment counter cyclical bank lending executed immediately in 2009 I haven't think that was a terrible idea but the point is they had that option you might remember President Obama in 2009 bemoaning the fact that U.S. banks wouldn't lend China didn't have that problem you give up a lever over the economy in addition to all the stress that real financial reform is going to give you years of of spikes and people saying what's going on in China and China is ruined and all this you give up a lever of reform so I think the pathway here is pretty clear to a real solution but the political attractions to not doing that are extremely strong just shifting gears a little bit I'd like to get your guys' view on something that's a little more political strike we saw of course last week I believe it was they finally or two weeks ago now maybe they finally rolled out what looks like the membership of the new leading group on comprehensively building reform it's been interesting that at least in the print media they've only really talked about the chairperson and the vice chair persons you had to really watch the CCTV to see everyone else in the circle and figure out what's going on obviously it does suggest very strongly the reason why Xi Jinping has been named the chair because they're clearly by the membership addressing issues well beyond simple economic issues but I'd like to get your read on the economic team players that you saw there and is it encouraging are there people that are missing that you were surprised aren't don't look like they're part of the process or the reverse some there that that should be well I'll begin by confessing I didn't watch CCTV so I don't know who's in the leading group but I do have one comment in that I think yes Xi Jinping is the chair and it's partly because the remit of the organization goes far beyond the economic sphere but I do nonetheless think it's very positive that he's taking ownership of this and I think this is very different from what we saw in the last 10-year run of Hu Jintao and Wen Jiabao and I think the fact that the president party secretary is putting you know taking ownership of the entire reform package gives it a much better I'm not saying it's going to all succeed but it gives it a better chance for moving ahead in the economic sphere but also in other areas so a lot of people are wringing their hands so Li Kechang is being eclipsed as this you know I don't buy that at all because most of what was in the third plenum document in substantive terms at least in the economic domain was exactly what Li had been talking about from the time of the NPC on when he assumed office and right up to the present so I don't see a lot of daylight between the two in terms of the kinds of reform programs that they're outlining and the fact that she's putting his prestige on the line and taking ownership of the of this leading group on comprehensive reform I think is a plus I agree with that I just I'd echo your point on Li Kechang I mean you know to me it's just a fundamental misreading the viewpoint that he was somehow losing altitude if he didn't appear on there as a vice chairman then I would have been a little concerned but since he is I think we're probably gonna get now you can draw also a lot of conclusions about why Leo and Sean is on there for example but that's a whole separate issue you know I know a lot more about the about the things we talked about and could have regaled you guys for 15 more minutes at least of the facts and figures than I do about the personalities mostly because I don't care about the personalities you know I think I think I'm tentatively agree that having she associate it would be let's put it this way the absence of she being associated with this would be disturbing yeah well there's a leading group is going to run the economy and the you know the party secretary wants nothing to do with this at all that would be bad up beyond that point I don't think this is particularly interesting we need to see actual implementation of policies and that's going to require a coalition not only with the central government but down to the local government level I think when when when Jew was that sort of dump shot pinks hatchet man and you know made all those enemies and run rough shot over them although then we had that reaction when he was removed from office I think the their problems were simpler I'm not saying that they were you know China's economy is worse now than it was in 1995 or anything like that I'm just saying your problems were simpler I think now you need a bigger a bigger group to take actions on multiple fronts so it you know I think the necessary condition is to have she there now we need to see who's who's going to run the show and finance I don't think it's going to be Joshua Schwann I think he has too many enemies and he's too old this is a long-term process who's going to run the show in in heavy industry what you know is a bastion of political opposition because there's so much over capacity and they benefited so much from subsidy you know those kind of people this the the full step below she not just Lee but but another step down that's the first question of the central government and then their allies at the local level so I just think this is a much more complicated situation than it was when you when Jew was implementing reform and you know if we were sitting here five years from now looking back on a successful reform we're going to have a whole list of people that were involved sure yeah okay good all right well why don't we bring the audience into the into the discussion I'm sure certainly been a lot to talk about there so per standard CSIS practice if you would please identify yourself and also your affiliation and if you would please keep your question to a question let's keep the soliloquies to a minimum okay who wants to go first over here on the right thank you for doing this my name is Donghui with China Revenue Agency what is the impact of China debt issue on the US interest what are the implications of this issue to US-China relations thank you I guess I'll go first I want to say nothing right that's my immediate answer you know there's a closed capital account China's integration with the world economy for better world financial system for better or worse in my opinion is quite exaggerated there's certainly Nick references I get these calls every single day there are a lot of panic in Wall Street what about this what about that they're misreading this as a commercial financial system which is integrated with the rest of the world economy and it's not it's not completely unintegrated or completely uncommercial it's just I'm just saying that that that archetype of a market financial system that's tied to the world like like Europe is is just not true so I really don't see I think that I don't see any direct connection between the debt problem in US-China relations I do think we're going to get a preoccupied China thinking about its own economic problems rather than being really thrilled to meet US standards on a bit or TPP there's a lot of talk about that but I think the bit in the TPP will work if they fit into Chinese economic reforms what China is willing to do because this is not WTO accession where China is willing to change its economy because it's so valuable to protect that connection to the US this is we have things to do here that are more important than our relationship with you they overlap that's great but I think the US on the econ side I'm not even going to touch the security side way out of my league on the econ side I don't think there's a direct impact and I think what the US is going to have to deal with on the China from China is China is going to be putting their own problems first which they need to in the back there right back thank you Oliver Melton of the State Department Nick how do you fix the bond market which is another way of asking how do you solve the only problem that's harder than financial sector reform which is fiscal sector reform particularly if you don't have transparent budgets and transparent actually anything especially at the local government level be brief I think that maybe Derek and I disagree a little bit on this I don't think the bond market can all of a sudden take over from banking from the banking sector this is a very bank dominated financial system it's likely to remain bank dominated for a long period of time they have talked for 20 years about having a stronger more robust bond market and it simply has not materialized and the share of financing that's coming through the bond market is extremely limited and most of the bonds are being purchased by banks anyway so what's the difference if the bank takes out and gives the company a loan or buys their bond it's it's roughly the same kind of a transaction so I think fixing the bond market is going to require a lot of work just as improving the the banking system will require a lot of work I don't think the bond market is rapid development of the bond market is a silver bullet it should have been developed more rapidly over the last two decades than it has been there's still an enormous amount of work to be done and part of it goes back to this perception of risk part of it goes back to the fact that you don't have very many significant institutional investors which is absolutely critical for the development of a robust bond market I just one thing I agree with all that I didn't mean to act as if we haven't had 20 years of talking about the bond market the one way I think the bond market can move more quickly it's a crucial way but it's only one is that I think private participation in the bond market can expand much more quickly than private participation in banking just the size of the asset banking assets held by the state are so gigantic versus any private entry that I just don't see private participation changing the banking sector very much I agree with everything Nick said about the problems and the history of the bond market but I do think there's the opportunity for a faster role a faster change more quick effect from the private sector finally got it more quick effect from the private sector in the bond market than I see in banking and I think that would be positive granting all the difficulties that Nick touched on right here in the front Marcus Rodlauer from the IMF I agree with your judgment basically on the size of the problem and the current probably lack of an imminent crisis particularly because of absence of counterparty risk but two specific questions on on the default risk versus you know continuing with the current system and then also the root of this local government problem Derek you were quite clear saying that the absence of a crisis is largely related to the absence of counterparty risk now in a situation where you have a lot of contingent debts both on local government but also elsewhere wouldn't the sudden introduction of major counterparty risk create the potential problem I'm not thinking of a layman type event but you know suddenly removing all that with the stroke of a bend through a major default in the system I guess would pose a risk and the government is very aware of that so in the end the issue is not sudden large default the issue is how do we calibrate a gradual introduction of risk awareness maybe through some haircuts here and there a lot of work behind the scenes but I'm a bit worried about this this recommendation of going all out and create a major default wonder your opinion about that and maybe sort of you know just not paying interest for three years which is about a 25 percent hair cut maybe that's a calibrated measure that could start make a good start second point is I kind of see the problem on the financial side financing side for local government debt it's a bit simplistic to think that you can solve the problem by just cutting off finance or stopping the whole machine of government debt accumulation and I think Nick's point of the real issue is how to get a gradual reduction of the pace of debt accumulation again you can't achieve that by suddenly cutting off financing allowing them not to borrow anymore you have to continue because as we know the large sort of macroeconomic deficit if you count all these debt accumulation is somewhere on the order of 10 percent of GDP if you wind that down to zero in one stroke of a pen you get a major contraction of growth so the question is really what does it mean to gradually reduce the pace of that accumulation what sort of spending should gradually be phased out at a time when you also want to increase probably some spending of the local governments on social security the debt financing costs are increasing so just simply saying this has to stop I think obviously Nick and you very well so where's the root of the problem the root of the problem is in the local government finances how they are organized the lack of revenues they have the kind of spending commitments they have so I think that is a problem that needs to be addressed but again in a country that has 35,000 local government units with vastly different conditions solving that with a stroke of a pen from the central government is not possible so it has to be very gradual and it's a complex issue thank you thank you I want to answer because gradualism always sounds so reasonable and I pride myself on sometimes maybe too often being unreasonable of course you're right that and I didn't mean to say that I thought we should cut off local government financing entirely if I said that I would draw it and I don't think I did I may have given the impression that I wanted to be rather dramatic in some of my treatment it wouldn't actually be of local government debt as I said I don't think the local government debt growth rate is nearly what people are saying when they compare the two audits I think the main problem in debt is elsewhere it's connected to local government debt but I don't think that you need a dramatic solution on local government debt because I think that's just symptomatic of a problem I will make the argument against gradualism on two grounds one is the obvious one which is we've seen Chinese gradualism in the financial sector and actually thanks with a partly push from work by Nick wonderful work in the 90s the Chinese tried this gradual approach and they made improvements 98 to 2007 I think the overall health of the financial system was improving there were some drawbacks and then they threw it all out the window not gradually very suddenly and dramatically and I think at some point you have to pick a problem and say not local government debt it would not that would not be in my case and take a dramatic action you know somebody said you so you'll accept any default all defaults are good I can imagine some defaults are bad but I think the growth of entrusted loans separate thing they both use the word trust but the growth of trust activity these things need to be checked now they're connected to local government debt they're less transparent they're a bigger danger so I wouldn't bring the hammer down on local governments for exactly the reasons that you talked about but my suspicion of gradualism in the Chinese financial context is extremely high if someone made wanted to make a case where this is the point where I want to take dramatic action and it's not the point where you want to Derek on the corporate side I'd say fine make it someplace else but this you know I feel like a statement from Beijing saying we're going to gradually change the way we do things is going to be heard as I don't have to do anything right now and is China at a crisis point no it's obviously been a theme but they're headed in the wrong direction and I'd like I'd like a direction reversal as soon as possible well I would I would say several things I think they do need a more regularized local government debt market where infrastructure that has long-term payoffs can be financed with longer-term funding they can't continue to finance long-term infrastructure investment with one-year loans two-year loans three-year loans so I think that should be you know high on the list of priorities maybe even higher than the than the corporate debt market secondly I don't agree completely with Derek about everything went out the window after 2007 in terms of improving the banking system in the crisis more money went to the private sector than ever before by 2011 private companies borrowed in absolute terms twice as much as state companies and I don't think it's a mystery private companies have a very high return on assets it's in the neighborhood of 13-14% state-owned companies today and I'm talking about traditional state-owned companies plus the broader universe of limited liabilities and limited shareholding companies where the state is the majority or dominant or sometimes the sole owner their return on assets is less than the cost of capital they're at under 5% in the average lending rate out of the banking system on a weighted maturity basis has been in the last couple of years something that I don't remember exactly but it's in the neighborhood of six and a half seven seven rising up to seven and a half percent so I don't think it's a pry I think it's a good sign that the banks have went a lot more to private companies over the last few years because they're much better credit risks than state companies they have much higher return on assets and they're going to generate more growth and I think that's the direction they have to continue to move in and that's why I think interest for liberalization is so important because as rates go up the state sector which is more highly leveraged is going to get less capital they're going to get a lot less lending from the banking system and so their footprint will will you know the shrinkage of their footprint could even accelerate which would be a very good thing for overall macroeconomic growth in China can I just say I mean this actually does Nick just gave me a way to make this disagreement we have relevant to the current conversation I agree entirely with the rate of return numbers I don't agree that private entities received twice as many loans in absolute terms as state entities that's a definitional difference again like our definitional difference over investment and the reason that's important so so just put that out there the reason that's important is because I see the modified again these are different kinds of entities than they were 20 years ago there's no argument but the modified state role in the economy still being extremely large is that that ties into our interest rates of the solution so charging higher interest rates to state entities my suspicion is state entities won't actually pay the higher interest rates and Nick has has sees a trend where the private role is expanding there's less there's less role that's lending to state entities because their lower rates return I agree with him on the lower rates of return and so he thinks that a higher interest rate is going to is going to squeeze the state sector more and this is a this is a positive development and I'm much more suspicious I looked at what happened in 2008-2009 I don't count the lending the same way and I think higher interest rates apply to the private sector not to the state sector and the private sector probably could stand some higher interest rates as well but this is a key part of the overall debt debate I think on local government debt Nick and I agree you know largely agree and you know very close to agreement I think the overall debt problem I see as getting considerably worse and I think the numbers reflect that and I think you see a much more mixed and possibly more optimistic picture right here in the front could just hold on for the microphone please I'm Jennifer Lee with Hong Kong Phoenix TV my question is regarding the impact on the China's economic growth so many institutions including the IMF they predict that China will have slower growth going forward due to the economic reform from the rebalancing from the investment to consumption and now solving the local government debt is their priority so do you think how the local government debt problem will play a role on China's economic growth going forward thank you well as I understand your question I think what I would say is if there's not a change in the growth model I think growth could slow down quite a bit too much money is going to firms as I just indicated that our earning returns that are less than the cost of capital that is not a recipe for sustaining economic growth so if we don't see the kinds of reforms that were outlined at the plenum on a fairly I agree with Derek on this some of these things need to move forward a little bit more rapidly gradualism maybe needed in some areas but not in all areas so I think if we don't see more reform going forward the growth will slow down I think with sufficient reform that they can continue to grow at you know seven seven and a half eight percent over the next few years it has everything to do with the allocation of capital in my opinion they continue to improve the allocation of capital I think they'll keep growth up but they're going to have to open up a lot of sectors to private sector participation which they have not done particularly in the service sector in manufacturing now the role of the state is very very small if you look at investment in manufacturing only 10 percent of it is now being undertaken by state companies but in the service sector it's a very different story and if you start disaggregating the indebtedness of state companies it's risen much more in the service sector in the last few years than it has in the manufacturing sector now there's some obvious exceptions in manufacturing but on average leverage has gone up more in the service sector and the return of state-owned companies in the service sector is even worse than it is in manufacturing so they're going to have to liberalize access to the service sector get rid of the you know the licensing and regulatory constraints that impede the development of the private sector in services starting with financial services but a broad range of other services that are still very very heavily state dominated I think next point and I agree with the theme so I'll just make two one extension then one thing that he won't want to be associated with at all but I did agree with the theme that what he just said points out that the manufacturing to services rebalancing which doesn't get enough credit versus the investment consumption rebalancing one is a you know there are different kinds of rebalancing that can go on with economies is a crucial one because what we want is an increase in private participation in services and a shift of locusts of economic activity to some extent because of that just because right now the return on capital and the performance of service firms is really depressed by the the state role so we should see services performing better if there's real reform and real privatization and that will automatically constitute rebalancing the other thing I would tell you and I'm sorry I've made all of you part of the crusade GDP growth doesn't matter okay it's a lousy measurement in the United States and it's an even worse measurement in China and this seven to eight percent stuff came up from a made-up reading of the labor market that took on a life of its own because it was a signal to the provinces of what kind of growth they were to announce not because it actually made sense you can have labor intensive growth you can have capital intensive growth we should want a lot of the creation of Chinese over capacity which is a huge problem in the economy recognized by the government added to GDP statistics year after year after year so we should want that to be removed and GDP growth therefore to fall now that's holding everything else constant which is not you know a fair assessment but just the idea that if Chinese that Chinese GDP growth has fallen from you know better than 13% it was 14% actually on the revised estimate that to sort of barely half that and this is a disaster that's not the problem the problem is waste and creation of over capacity China can be an extremely healthy dynamic prosperous economy at 5% GDP growth so we just you know I understand your question that's what everyone thinks I just said you know defaults aren't necessarily bad they may very well be good GDP growth is not a sign of health or illness yeah yeah yeah uh oh the hosts are intervening thank you Matt Goodman at CSS a really interesting discussion I'm still trying to digest all of it so I'm not even sure this question is right but I think it just sort of tees right off what you just said Derek which is whether growth is the right measurement or not isn't it still hardwired into the system of sort of political economy there that local governments still feel that they have to breach some sort of growth target I mean until those incentives change are they going to be able to really control the this problem and and are they going to be able it seems hard to see how you're going to get out of a of a debt problem without where people are still incentivized to you know borrow and spend waste which seems to be the way the incentives are still structured you're right yeah is that changing as the third plenum document had any impact on those local incentives well if you look back of people's daily editorials in 2004 they say China is going to stop emphasizing the quantity of growth and emphasize the quality of growth that was 2004 they've been saying this forever so you could take a very cynical view and say yeah right the plenum says they're going to change I don't believe it and I agree with you that it's going to take a while for the incentives to change down the local level here's the one reason that I have hope for my crusade in China the labor market has definitely shifted it's not that there are no there's no excess labor supply in many cities it's just that we've gone from a period of increasing number of entrants every year and an ever rising labor force to where the government is at least publishing statistics so they don't see they have a reason to deliberately falsify where they say the labor force is shrinking and there are some places where you don't need to just create jobs to employ people to keep them off the streets this is going to take a few years to filter down but if we can break the link that was always false between the level of GDP growth and employment where employment is the party's real political imperative then I think you have a chance of local officials saying you know we don't need to say you know Inner Mongolia doesn't need to say we grew at 18% last year right they're not going to need to say that but your point is taken it's not going to be a snap your fingers as we announce quality over quantity and now the growth figures are don't matter anymore but I think there's a fighting chance with the shift in the labor market that we can get away from this obsession at the local level well they've talked about it about downgrading you know GDP growth is a metric for judging successive local leaders but as Derek said they've been talking about it for a long time I happen to think they're more serious now and they've raised up some other criteria environmental improvements and things like that so I think we will see a change over time but it's going to take it'll take time to play out I mean I would just add that the party's organization department which manages personnel has put out an instruction along these lines after the third plenum I mean you know implementation like all these other things we've been discussing is the issue but they don't do that lightly I guess I would just interject on that yeah yeah right here in the middle wait for the microphone please thank you reporter from the Voice of America Derek you mentioned in part things that the comparing to the local government debt corporate debt is a big problem could you elaborate on that and my second question is what is the biggest challenge for Chinese ACAR in 2014 thank you okay all right you know I've seized on corporate debt look all these debts are related local government debt is related to banking debt directly you know the entities involved are related the debts overlap it's all related problems so when I say this is symptomatic of a failed development model I mean the overall increase in debt and you know pushing it one way or another way is not local government debt problem by itself I don't think is that is that worrisome so I picked out corporate debt because we have talked and Nick has done marvelous work over the years on bank on the banking side we're now talking about the local side people cover the corporate side but I don't think they cover it enough Chinese firms you know are over leveraged compared to any measurement of their peers the aggregate they're over leveraged the top firms are over leveraged everybody is over leveraged we saw that I'm just trying to draw a comparison that it's not a very good comparison about the effects you can hollow out a corporate sector there are now some Japanese firms that are that are competitive at the world level but the Japanese corporate sector as in terms of being based in Japan has been hollowed out that's what happens when you're over leveraged for an extended period the Chinese system is different the resolution will be very different but I'm just trying to give you an indication of the danger Chinese you know depending on how you measure it there is the Chinese corporate debt again these the old figures are very suspect and sort of what the corporate debt used to be so this is this is a qualified statement there's no major economy that shows that the pace of corporate debt accumulation that China has shown in the last 10 years if the numbers before were were close to accurate so I just see that as the sharpest indication of unsustainability not because it's not it's connected to everything else you can't just solve this problem in isolation obviously you can't solve a corporate debt problem in isolation without addressing the banking system in turn you know quickly on on what the biggest challenge is for China I think the biggest challenge for China 2014 is purely a policy challenge it's not it's not an actual on the ground real economy challenge it's what are they going to prioritize in their reforms because even if you believe that there is a real commitment to reform all these people in the leading group are going to be standing around looking at each other saying well what what do we do now what do we do early in 2014 what do we do next and that that's a big art that's a big argument to try to settle so I picked out corporate debt because it's symptomatic and because the numbers I think don't get quite as much attention as they should it's tied to this larger problem of debt accumulation versus growth and then the challenge is going to be how to sequence the policy changes well I just add one qualification and that is yes corporate debt is relatively high as a share of DEP or any other metric you want to use but if part of the part of it is there is very little equity finance in China the equity market has not developed very rapidly we know we've had no listings for 14 months so if you compare China with a universe of companies in countries that have bank dominated financial system it doesn't look like so much of an outlier it certainly looks like a huge outlier compared to the U.S. but you know U.S. companies get almost none of their financing from the banking system they're getting it from the equity markets and other sources so if you compare China with a universe of bank dominated financial systems yes they're still an outlier but it's less so would you then locate my problem as as something you said before the real challenge here is to move away from being a bank dominated financial system would you is that a fair assessment that you know one way to see the problem yes yeah I think you know they need to have more equity financing for the corporate sector definitely it's more stable and you can't you know I agree there are risks running on a you know running up very high levels of debt in a in a bank dominated system I I don't think bank dominated systems are the best are the best model and so I think we both agree the model needs to change all I'm saying is that China's level of corporate debt does not look as much of an outlier if you compare it with firms or in bank dominated financial systems an interesting implication of that which you know something I I don't know if anyone in this room takes the Chinese stock market seriously as a stock market don't if it's making you money great but don't take it seriously as a stock market but what Nick just said is you got to take it seriously as a stock market I mean it's something we haven't talked about in connection to financial reform if you don't fix the stock market it makes the banking bond market challenges that much harder and the reason I bring that up is to get to your question it's very hard to isolate a problem that way and that means you have a whole set of things you want to change banking bond market stock market is just the financial side so again the sequence that they choose is really important and if they're paralyzed by how hard that choice is that's the danger here sir wait for the microphone please thank you my name is Huang just a confidant from Beijing and from Taixin Media so I'm a good question about the regulation because we know that CBRRC and the central bank PBOC have different view about the regulation of straddle banking in general and P2P in particular what's your take on this issue that different government agencies about the regulation problem well I think that there obviously is some daylight between CBRRC and PBC on regulation with PBC taking a more cautious approach and wanting to scale things back and CBRRC being more responsive shall we say to some of the pleas from participants in the financial sector I think in some ways it's very similar to the U.S. new rules are proposed then the bankers all run in and say oh it will be the end of the world if you introduce these higher standards and more regulation and more capital and more liquidity we won't be able to lend very much and GDP growth will go down there's some flavor of that going on in China when PBC is trying to scale back and CBRRC thinks that it doesn't want to move quite so rapidly how it will all work out I don't know I think the basic problem in China is that that you know there's too much inner flow of high level personnel between the central bank and CBRRC in the bank heads if you take the whole post-World War II period in the United States a chairman of the Fed or vice chairman has never left the Fed and gone to run a major commercial bank that happens all the time in China these guys just rotate back and forth and I think it makes it very difficult for the regulators to crack down on the banks most of them expect to be working in these banks sometime in the next five years so it creates I think a systemic problem I'm gonna say I'm very distrustful financial regulation in general for the reason I said right at the beginning I think it always lags I said the first thing I said subsequently was financial regulators always lag behind so of course you have to have prudential financial regulation but if you're flooding the system with money it won't matter money will overcome everything I built a new dam and the water will just flow right on over it if you have too much money so I think the battle with the people's bank is having with the BRC is secondary the people's bank needs to hold the line on tightening the money supply and then all the regulatory problems will become easier if they don't do it it doesn't matter what they do on the regulation so you know I have I have associates that people I know at the PBOC I'm like don't get distracted by regulation if you cannot control I mean Chinese M2 is bigger than American M2 much at this point I mean this is just you you've got to address this problem first and then deal with regulations after that Rebecca Hi uh David Parker from CSIS thank you for all of these discussions for particularly on the government that issues you covered done a great job covering assets liability funding mechanisms one question I had was about revenue and tax reform something that was certainly discussed in the third plenum document that minister low was main statements about sort of institutionalizing some of the fiscal transfer system and reworking some of how the tax system actually works I'd be interested in your comments on where that needs to go or is it a major issue moving forward in the near term thank you no it's certainly a major issue I mean we we have you know originally we had a local SOE local governments were dependent on local SOEs for revenues so there was a lot of subsidizing of local SOEs because what was good for the local SOE was good for the local government and by the way the SOE from the neighboring province or even you know below that level the neighboring township isn't as good because we don't get revenues from them so you have local protection problems that has been supplanted in recent years by by dependence on property tax revenue which we know is not sustainable over time because the famous saying you know they're not making any more land by land because they're not making any more of it so you're going to run out of options there so the revenue side is difficult I have to say I don't know enough about the variations in local tax situations to make really good suggestions because I think you know how can you possibly compare you know Shenzhen to to you know rural areas in Ningxia I mean it's it's not going to be able to to come up with a one-size-fits-all solution I think the you know what I'm familiar with at the central level you're going to need you know to raise central government collected taxes and redistribute them that's the that's the the easier solution while you try to figure out what different localities situation is I think at the central government level they're doing this now they they're pilot tax reform projects ideally they would move toward putting more stuff on budget away from SOEs which means you need more tax revenue that's a very very difficult challenge there's a you know the SOEs are already paying a lot of taxes we have a you know sort not underground economy but half above ground economy where the private sector doesn't pay much in the way of taxes I think we're slowly moving to the point where so here's I sound a more optimistic here from what I can answer the central government is is the short-term solution to the tax revenue problem of local governments and the central government is moving in the right direction it's moving slowly in the right direction which means we still have an acute local revenue shortfall but I think I don't know enough to tell you here's a set of solutions for local government revenue-raising that's going to work in large portion of the country well I think I mean I think the key is going to be assigning more revenues to local governments local governments spend twice as much as they collect they're heavily dependent on transfers from the central government this you know creates a bargaining situation local governments don't know year to year what what they're going to be able to finance and I think there needs to be a major structural change so that local governments have more assured sources of funding they've got lots of unfunded mandates now it's led them to become too heavily dependent on land revenues I agree I agree with that but that was the that was their only choice so that's I think the basic direction things have things have to go to go in you know the VAT reforms they're implementing it's very slow because they're scared of throwing things off but you can imagine a VAT system that raises enough money at the central level where if it's transferred back you can address these problems I'm not saying that they are that it will necessarily work out that way but I do think the central government is aware of this and is trying to figure it out the question is whether too much dependence on property tax revenue and debt accumulation is moving too fast for this very tentative tax reform okay I think we have probably time for one more question thank you my name is Jeannie we're in good voice of Vietnamese Americans you have said from the beginning that China Chinese market is not a free market it's not a commercial so the standards are very different and you also made it clear that all the numbers not dependable so and the GDP growth all that numbers are not dependable and it's been very clear that they may not be able to liberalize the interest rate equally so the disparity is something that they cannot avoid in the country and the land situations so how old how does all that affect the stability inside the country and how does that affect the peripheral nations around along China especially Vietnam because most countries when we interest with China always running to significant trade deficit and China now has affect the economy of the whole region especially South East Asia recently after the recent epic they signed many agreements so how does that affect the region the stability and how does that transfer into Chinese actions politically their aggressiveness in the region thank you I'm not going to answer the political question let's just get that on the table I think you know the trade the Chinese trade patterns are going to change over time it's an older society than it was 10 15 years ago older societies tend to produce less and consume more I think there's a there's an attempt it may be weak policy attempt to add to that the policy attempt could fail entirely and structural changes are going to make China consume more so I think you're going to get a change in Chinese trade patterns where they they don't push out as many manufacturing goods there's still a huge manufacturer still a huge trade I'm not I don't mean to exaggerate this but but the shift is going to be over time where I think maybe the commodities countries that sell commodities to China are going to are going to see some stagnation and their rates of of export growth to China I think countries that import manufactured goods are going to see less Chinese growth in manufacturing so I think the countries that are facing acute trade imbalances with China I suspect those will ease over time it may not happen very fast certainly won't happen as fast as India wants it for example but I think where we're past the peak period of Chinese huge Chinese manufacturing trade imbalances and we're moving towards towards a more balanced period okay well a couple things are clear to me one this is going to be a perennial issue so we'll have you guys back shortly and continue to watch it going forward I know as a economically person I certainly consider myself to be greatly enriched by the discussion please join me in thanking the panel and thank all of you for your great participation