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Taming Financial Cycles Carefully
 NO. 49 DECEMBER 7, 2017
A residential complex in Changchun, northeast China's Liaoning Province (XINHUA)
While the markets debate China's latest round of economic growth, national regulators are focusing on an equally important factor in the economy—financial cycles.

In its latest quarterly monetary policy implementation report, the People's Bank of China (PBOC), the nation's central bank, devoted a special column to this concept, describing it as an "increasingly significant issue" that should be handled with macro-prudential approaches to prevent systemic risks.

"While traditional monetary policy can address instability during economic cycles, it is not effective enough to balance controls on economic and financial cycles, which are caused by the expansion and contraction of financial variables," the central bank said.

The global financial crisis showed that traditional economic indicators, like GDP growth and inflation rates, were not necessarily linked with financial stability.

Leading up to the U.S. subprime mortgage crisis in 2007, the global economy was rising strongly with steady inflation, but skyrocketing stock markets and housing prices sowed the seeds of the crisis.

"When economic and financial cycles do not move in sync, they may lead to different or even adverse effects, thus making macro policies conflicting and ineffective," the PBOC said in the report.

The central bank's concern is in line with those of many other governments and international institutions, who warn that the ups and downs of financial cycles may span economic cycles and could even lead to a future crisis.

In its annual report earlier this year, the Bank of International Settlements noted the looming risks triggered by financial expansion in several countries, saying "the main cause of the next recession will perhaps resemble more closely that of the latest one—a financial cycle bust."

The issue is particularly relevant in China nowadays as the nation works on deleveraging and puts tough curbs on the property market in order to defuse risks and asset bubbles, both of which are considered key indicators of financial cycles.

"The impact of financial cycles on the macroeconomy is not short-term fluctuations, but rather mid-term ones," said Peng Wensheng, global chief economist with Everbright Securities.

To better harness financial cycles, the PBOC, like many other central banks, has adopted a policy framework that involves the use of both monetary tools and macro-prudential regulation to make counter-cyclical adjustments.

Under a "twin pillar" framework, the central bank has established a macro-prudential assessment framework to regulate financial institutions and for liquidity management has increasingly relied on monetary tools like open market operations, rather than adjustments in interest rates or reserve requirement ratios.

The "twin pillar" framework was emphasized in the key report delivered to the 19th National Congress of the Communist Party of China, which reiterated efforts to improve the financial regulatory system to forestall systemic financial risks.

China's overall leverage ratio is still growing, but at a slower pace. Overall leverage was 257.8 percent of GDP at the end of the first quarter of this year, up slightly from 257 percent at the end of 2016. The non-financial corporate leverage ratio declined to 165.3 percent at the end of March from 166.3 percent at the end of 2016, according to the Bank of International Settlements.

The Chinese Government has also stepped up scrutiny to stem malpractice in the financial sector and placed strict controls on the real estate market to curb speculation.

"Deleveraging is a slow and complicated process, and the permanent cure to high leverage risks is solving structural issues," said Zhou Yueqiu, director of the Urban Finance Research Institute of the Industrial and Commercial Bank of China.

Peng also said that although the possibility of China seeing a systemic financial crisis was small, it did not mean that the real estate and financial sectors should seek unlimited expansion.

"To make further financial structural adjustments, China should increase the use of fiscal tools in the money supply, instead of only relying on bank credit. Meanwhile, the government should strengthen its ongoing regulatory scrutiny to curb misconduct in the sector," Peng said.

This is an edited excerpt of an article originally published by Xinhua News Agency

Copyedited by Chris Surtees

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