Philip Lowe on why the RBA is watching China's debt mountain so carefully

Australian Financial ReviewMay 23 2018 9:12 PM

Jacob Greber, Lisa Murray

Reserve Bank of Australia governor Philip Lowe has appealed for calm over Australia's increasingly troubled political relationship with China, while warning that its ballooning debt mountain and opaque financial system pose a threat to prosperity here.

Seeking to take heat out of the debate over China's role in Australia, Dr Lowe said it was important to build understanding, connections and multiple lines of communication.

He said while every relationship had its ups and downs, "I do think it's important that we avoid escalating issues when they arise."

In a speech on Wednesday night Dr Lowe detailed his concerns over China's banking system, which he says is the most likely source of an economic shock.

"Not surprisingly, this risk has become a priority of the Chinese authorities - we all have a strong interest in their efforts being successful," he said.

Tapping the Reserve Bank's extensive network of officials - it has more staff studying in China than in any other overseas country - Dr Lowe said Beijing's authorities were working hard to address the debt threat.

"It is too early to tell whether the authorities will be successful in managing the transition from a growth model heavily dependent upon the accumulation of debt to one where credit is less central.

"It is a very significant task. The experience of other countries suggests caution and, elsewhere, there have been serious accidents along the way."

Speaking at an event hosted by the Australia-China Relations Institute in Sydney, Dr Lowe alluded to the financial calamities that Australians faced following the initial deregulation of the banking system in the 1970s.

"As some of the regulations were eased here and more things became permissible, we too saw new institutions emerge – just has been the case in China – to sidestep the regulations that remained.

"In our case, this did not end well! This helps explain why we are watching things in China so carefully."

However, Dr Lowe said he was "optimistic" about China's ability to address vulnerabilities in the financial system

"The Chinese authorities have managed the task of keeping the economy on a reasonable growth trajectory for quite a few years. I'm optimistic they will continue to do that.

"Many other countries have had to address problems in the financial system during a crisis. The Chinese are doing it beforehand."

Dr Lowe again invited China's leaders to learn from Australia's experience, and repeatedly used his speech to hammer home the need to improve a relationship that has been heavily strained over the past year or so. He called for greater links across business, finance, politics, academia and the community.

"We will, of course, have differences from time to time, but we will surely be better placed to deal with these if we understand one another well."

Asked whether the more protectionist approach of the Trump administration in the US was motivating China to accelerate reforms, Dr Lowe said increasingly Beijing was "a voice for the open rules-based international trading system."

He said that was one of the common interests that "binds us together" and could help Australia and China through volatile periods in the relationship.

The governor's twin concerns - on debt and the state of the relationship - were the subject of a special discussion in the Reserve Bank's May board meeting, and underscore the degree to which both issues are intertwined.

Analysis by the bank's staff shows that so-called shadow banking accounts for around 45 per cent (up from 25 per cent 10 years ago) of China's total debt - which has galloped to 260 per cent of gross domestic product.

Simultaneously there are now more than 3500 institutions channelling money into the economy through opaque structures such as trusts.

'Quite different to the normal pattern'

Dr Lowe said the debt surge was unlike anything recorded over the past decade among either advanced or developing economies.

"What has happened in China is quite different to the normal pattern," he said.

Even though China has liberalised much of its financial system, loosened interest rate controls and capital flows over the past decade, there is still much to be done, he suggested.

"It is worth recognising that, taken together, these are significant changes. A decade ago, many outside observers were sceptical that the Chinese authorities would undertake reforms across many of these fronts.

"Yet they have made significant progress. Despite this progress, there is still much to be done before the Chinese financial systems looks like financial systems we see in the advanced economies."

Dr Lowe also cautioned that any liberalisation of China's capital account must be done gradually.

"If Chinese citizens can buy and sell foreign assets just like you or I can that will have really profound implications for global capital markets," he said .

"We see evidence at the moment in some countries where Chinese citizens have wanted to buy property assets and that's forced up property prices," he said, nominating Australia as one of the places that's been affected.

"That's been manageable but if it were on a much larger scale -- which it conceivably could be -- it would be problematic."

Urging Australians to take a broader view of China, Dr Lowe pointed out that services and direct investment are becoming important drivers alongside the traditional resources trade flows.

"Too often this relationship has been viewed largely through the prism of resource exports," he said.

"These exports are certainly important, but this perspective is too narrow. Over time, we are seeing a broadening and deepening of our economic relationship with China."

By way of reminder, he noted that the deepening of the economic relationship is benefiting both sides.

"It has created new opportunities for us and significantly boosted our national income. It was also one of the factors that helped our economy through the global financial crisis.

"The deepening relationship has also benefited China in many ways.

"This means that both countries have a strong interest in managing this important relationship well. It is in our mutual interests to do this. Together, we can also be a strong voice for the importance of an open international trading system and for effective regional cooperation."