Photo: Steve Passlow Key takeaway – Over the last three decades, China’s contribution to global growth tripled. The interplay of three domestic factors enabled a growth acceleration: abundant cheap labour flocked into the industrial sector and accepted the financial repression of its savings, which in turn funded massive investment via subsidized lending to state-owned enterprises (SOEs). In other words, captive savings, channelled into captive investments, enabled an export-led strategy but – because of capital controls – created bubbles in the few asset classes available to savers. Over the last two decades, real estate investment rose by almost 300 percent; over the past 10 years, the size of the shadow banking system (SBS) multiplied by 50; between 2014 and 2015, the stock market rose by 150 percent. This model is now exhausted: current demographic trends will not deliver a labour-surplus; savings are less and less captive and less and less prone to subsidize lending to SOEs. As a result, China’s potential growth has declined, from about 10 percent to 5, and even such level could soon become an ambitious target. Over the last three decades, China’ contribution to global growth tripled. The Communist Party of China (CPC) – the Republic’s founding-and-ruling political party – started reforming the economy in 1978.
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photo: Steve Passlow
Key takeaway – Over the last three decades, China’s contribution to global growth tripled. The interplay of three domestic factors enabled a growth acceleration: abundant cheap labour flocked into the industrial sector and accepted the financial repression of its savings, which in turn funded massive investment via subsidized lending to state-owned enterprises (SOEs). In other words, captive savings, channelled into captive investments, enabled an export-led strategy but – because of capital controls – created bubbles in the few asset classes available to savers. Over the last two decades, real estate investment rose by almost 300 percent; over the past 10 years, the size of the shadow banking system (SBS) multiplied by 50; between 2014 and 2015, the stock market rose by 150 percent. This model is now exhausted: current demographic trends will not deliver a labour-surplus; savings are less and less captive and less and less prone to subsidize lending to SOEs. As a result, China’s potential growth has declined, from about 10 percent to 5, and even such level could soon become an ambitious target.
Over the last three decades, China’ contribution to global growth tripled. The Communist Party of China (CPC) – the Republic’s founding-and-ruling political party – started reforming the economy in 1978. As reforms kicked in, the annual output grew thirty-five times, from US Dollar (USD) 300 billion (bn) in 1978 to more than USD 10 trillion (tn) in 2015. In the same period, China became the fastest-growing large economy in the world, and its contribution to global growth averaged 18 percent in the 1990s, 24 in the 2000s and 36 in 2010-2015. Over time, such a rise supported growth and improved business and consumer confidence in many countries across the globe. In the consumption-oriented economies of developed markets (DMs), China’s low prices kept inflation in check and enhanced shoppers’ purchasing power. In commodity-producing emerging markets (EMs), China’s appetite boosted exports and spurred performance via larger trade and capital flows. China’s economic influence is now sizeable in most countries.
Box 1. Understanding China’s growth: the dual-sector model
|The dynamics of China’s growth can be explained by the dual-sector model: at first, a developing economy has: a) an agricultural sector with surplus of unproductive labor; and b) a growing manufacturing sector, where wages are higher than the marginal product of labor in agriculture (i.e., subsistence levels) and fixed. As workers migrate to manufacturing, employment and saving rates rise. Entrepreneurs profit because sale prices are above fixed wages. When sale volumes grow, profits rise as share of income and are reinvested into fixed capital. Capital accumulates and economic growth accelerates. The process of capital accumulation ends when: i) the rise of real wages reduces profits and hence investment; or ii) surplus labor is exhausted.|
Source: Authors’ elaboration, 2016.
The interplay of three domestic factors enabled growth acceleration. China’ fast-tracked transition was mostly driven by domestic factors (Box 1): 1. a large pool of labor-surplus; 2. high savings, kept captive by government policy; and 3. subsidized lending to – and the ensuing capital accumulation by – SOEs. The sustained expansion of the labor pool increased savings and, as a result of capital controls, investments. Between 1980 and 2015, China’s total investment as percentage of gross domestic product (GDP) increased from 34.8 to 43.3 percent. Over time, costs were reduced by investment-driven productivity increases, allowing for capacity expansion without loss in competitiveness.
- Abundant cheap labor flocked into the industrial sector … For 30 years, as farmers left rural areas to work in coastal production centers, rural-urban migration supported the transition from agriculture to manufacturing (Box 1). Yet, output growth did not translate into wage pressures: between 1978 and 2015, total industrial production increased 38 times and labor costs only increased 10 times. This is because China’s manufacturing workforce kept expanding. Between 1978 and 2014: a) the population grew by 42 percent, from 963 to 1,368 million (mn), despite the one-child policy; b) the urban population more than tripled, to 749mn; and c) the labor force grew by 92 percent, from 402 mn to 773 mn, circa 56 percent of total population.
- … accepted the financial repression of their ‘captive savings’ … For three decades, capital controls kept the capital account closed and savings “captive”. In other words, money could not easily leave the country; domestic investment was restricted to a few asset classes: a) real estate; b) products available in the SBS; and, more recently, c) stocks (Figure 1). In absence of alternatives – e.g., offshore real estate investments – and given the implicit government-guarantee on deposits held at large state-owned banks (SOBs), domestic savings accumulated into SOB deposit accounts. The People’s Bank of China (PBOC), China’s central bank, set the interest rate on deposits at artificially low – and even negative – rates (Box 2). While repressed rates depressed the purchasing-power of depositors, large SOBs were able to attract large sums. Between 1980 and 2013, gross national saving rose to one of the highest levels in the world. All sectors contributed actively: i) households saved because of weak social protection systems and the distortions induced by the one-child policy; ii) the corporate sector saved because of a lack of alternative sources of funding, given the low level of development of the financial system; iii) government consumption grew at a slower pace than its disposable income, while the PBOC accumulated foreign currency – resulting from trade surplus – by keeping the Chinese Yuan (CNY) undervalued.
- … and funded massive investment via subsidized lending to SOEs. SOBs lending to SOEs steadily transformed domestic savings into domestic investment (Box 2). While small and medium enterprises (SMEs) – lacking sound collateral – struggled to obtain funding, government-linked corporates enjoyed abundant, cheap and easy credit. Large-scale infrastructure and real estate construction projects managed by the Government saw their cost of capital dramatically reduced. SOEs were favored for a variety of reasons: i) implicit state guarantees; ii) lower credit risk associated with privileged market position; iii) CPC connections between SOE and bank management; and iv) SOB career incentives.
Figure 1. China – Capital controls generate captive savings
Source: Last census (2012), National Bureau of Statistics, 2016; Bloomberg, 2016; *From 9 May 2015 to 8 May 2016; ** Bond yield data prior to 2005 not available; ***Historical data not available.
Notes: 1. Green line: financial flows, blue flow of goods, black productivity enhancements; 2. In 2014, the gross saving rate, at 49 percent of GDP, was higher than in the United States (18), United Kingdom (12) and Japan (22); 3. In 2014, the average wage (USD9,200 converted to USD using the 2014 average exchange rate of 6.149 USD/CNY) was much lower than in the US (USD 57,300), UK (USD 51,200) and Japan (USD 33,400).
Box 2. Financial repression in China
|Financial repression is the result of policies implemented by governments to benefit from capital that, in a deregulated environment, would be invested elsewhere. Simply put, it occurs when interest rates (the returns earned by savers) are held below inflation. By transferring benefits from savers (the lenders) to borrowers via negative or below-market real interest rates, financial repression works as a tax on savers and bondholders. When accompanied by inflation, it becomes a form of debt reduction. By reducing the burden of repayments, financial repression allows banks to provide cheap loans to government entities. In China, low returns on savings made cheap loans to state-owned-enterprises (SOEs) possible; as a consequence, the economy could rely on savings-financed investments to grow.|
Source: Authors’ elaboration, 2016.
Captive savings, channeled into captive investments, enabled an export-led strategy … Directed credit boosted infrastructure expenditures. Between 1968 and 1978, gross fixed capital formation averaged 25.4 percent of GDP, compared to a global average of 24.5. Despite rapid GDP growth, gross fixed capital formation rose steadily as a share of GDP, and reached 44.2 percent in 2014. The majority of infrastructure spending was allocated to harbors, logistical centers, ports, hubs, favoring exports, which had averaged 3.9 percent of GDP between 1968 and 1978 but rose to 22.6 percent in 2014.
… but created bubbles in the few asset classes available to savers. Between 1979 and 2015, investment restrictions, accompanied by caps on returns of bank deposits and government pension plans, pushed yield-seeking investors into the few accessible asset classes: a) real estate; b) shadow banking products; and more recently c) stocks, creating a series of bubbles that now pose a threat to economic stability and increase systemic risks.
- Over the last two decades, real estate investment rose by almost 300 percent. According to the IMF, between 1997 and 2014, the weight of real estate in the economy increased from about 4 to 15 percent of GDP, the highest share on record, worldwide. Between 2005 and 2011, real estate activity and prices accelerated. Home prices rose 99 percent nationwide, at a CAGR of 9 percent. After the 2008 crisis, government intervention fueled a spike: in 2009 and 2010 sales of residential floor space grew between 100 percent and 150 percent year-on-year (y-o-y). Conversely, in early 2012 sales contracted at around 50 percent y-o-y. Given the high volatility, authorities regularly intervene to curb demand, by means of sales taxes, increases in down payments or restrictions in the number of properties a family could own. In 2013, prices started rising again, spurring a new government intervention; as a result, since mid-2014, prices started decelerating.
- Over the past 10 years, the SBS size multiplied by 50. In China, a myriad of non-bank financial institutions offer investments managed outside balance sheets which return higher interest than traditional deposits. Between 2002 and 2013, the sector grew by a factor of 48, rising from CNY 523bn to 25.0tn (from USD 80bn to USD 3.9tn, equivalent to 42 percent of 2013’s GDP), and became a systemic risk. The SBS is strongly interconnected with the real estate sector and the government is concerned that defaults that are already taking place in the energy and real estate sector might result into a full-blown panic, freezing credit into the economy. The country’s financial authorities have increased the supervision and regulation, trying not to suffocate the sector, which remains the main source of funding for most SMEs.
- Between 2014 and 2015, the stock market rose by 150 percent. Following the demand-curbing restrictions implemented by the government in the real estate sector in 2013 and the ensuing price deceleration, investors poured their cash – mostly savings, but also fixed-assets divestment – into stocks. The markets surged, also lifted by: i) a chronic shortage of alternative investments; ii) the adoption of new pro-investment regulation such as measures to facilitate margin lending; and iii) SBS institutions diverting funding from real estate to the stock market. In the first 5 months of 2015, 30mn new accounts were opened to trade in the A-share market. Between May 2014 and May 2015, China’s stock markets run: the Shanghai Composite index rose by 126 percent; the Shenzhen Composite index rose by 124 percent. In mid-2015, small investors drove 80 percent of the market turnover, increasing volatility.
The growth model is now exhausted. For three decades, captive savings served the country well, but the party is over. China is unlikely to grow again at similar rates.
- Current demographic trends will not deliver a labor-surplus. Adopted in 1978, population-control measures have depressed natural population growth. In 2011 the working age population declined for the first time. In 2012 the total number of workers peaked. In 2014, labor force participation declined. In 2022, China will be overtaken by India as the world’s most populous country and by 2028, if not earlier, the total population will start to contract. As a result, the pool of potential rural-urban migrants is shrinking steadily. Additionally, workers are less willing to migrate to distant coastal cities without having access to basic rights, like education or health. As an increasingly smaller workforce moves to manufacturing centers, the labour market tightens – i.e.: a labor-shortage increases the migrants’ bargaining power – forcing firms to improve working conditions and increase wages. In 2008, the government adopted measures to improve the conditions of migrant workers, aware that: i) the previous model could create social instability; ii) the corporate sector was capturing a disproportionate share of the income; and iii) higher wages and benefits could contribute to the desired increase in consumption.
- Savings are less and less captive … As financial markets develop, alternative asset classes become available, de facto reducing the deposit pool. Despite a changing regulatory framework, the bond market has grown sevenfold, from around USD 300bn in 2008 to USD 2.3tn in 2015. Stock markets have also developed fast: the joint market capitalization of the Shanghai and Shenzhen stock exchanges rose from USD 1.7tn in 2008 to USD 5.7tn in 2015 at a CAGR of 18 percent, fueled by an increase in initial public offering (IPO) activity. Shadow banking will keep attracting numerous individuals and corporates – hence capturing a larger share of savings – by offering investments in high-yielding sectors currently restricted by the government, such as real estate or energy. Finally, the government is making efforts to provide domestic savers with access to foreign markets, such as the Shanghai-Hong Kong Connect and the Shanghai Free Trade Zone.
- … and less and less prone to subsidize lending to SOEs. Years of cheap credit created overcapacity. As a result, the rate of return of investments declined making lending to SOEs less attractive. Additionally, the ongoing liberalization of the financial sector – by pushing banks towards a more efficient use of funding – and the exponential growth of the SBS are de facto reducing the availability of funds for SOEs. Indeed, SMEs are benefitting from increased lending because: a) the flexibility in interest rates setting – by reducing the spread between SOEs and SMEs – is aligning credit decision in large banks to market criteria, reallocating lending from SOEs to more efficient SMEs; b) SMEs are the natural destination of shadow lending as the SBS is not subject to caps on lending volumes, has lower capital requirements, no CB reserve requirements, no unrealistic non-performing loans (NPL) targets, greater price flexibility and better capacity to assess risk in smaller firms.
Box 3. A misunderstood slowdown
|China’s growth peaked in 2007. Since, most economists have underestimated China’s deceleration. Thirty years of real growth averaging 10 percent anchored expectations in double-digits and resulted in years of overoptimistic forecasts. The 2009-2010 post-crisis rebound was mistakenly taken as a return to the “normal” in spite of an abundance of data suggesting otherwise. Only recently, the new reality of low structural growth has started to be embraced, but some analysts still think a return to double-digits is possible.|
Source: Authors’ elaboration, 2016.
China’s potential growth has declined, from about 10 percent to 5, and even such level could soon become an ambitious target. Between 1980 and 2010, growth was driven by the interplay of three domestic factors – i.e., the captive savings model (rural labor-surplus, financial repression and subsidized lending to SOEs). Since 2010, the risks stemming from the captive savings model started to offset its benefits. In 2012, the Chinese authorities, aware of the need for transformation, implemented gradual measures to relax family planning restrictions, open the capital account, increase salaries, decrease lending to inefficient SOEs and reduce growth targets for regional and local authorities. Going forward, growth will decelerate to low single digits (Box 3), subduing the global economy for a substantial period of time. For years, China has increased the purchasing power of its trading partners, while reducing the purchasing power of its own citizens. Now it needs to do the reverse.
This is the first of three papers on China’s economic performance. Paper I focuses on past growth dynamics, paper II on present challenges, and paper III on future prospects. We thank Mert Yildiz for comments and suggestions, PulsarKC for data collection. All errors are ours.
 In late-1978, the CPC initiated the “process of economic reform” and gradually transformed central planning into a “socialist market economy”. The word “market” was included as an economic goal in 1992, during the 14th CPC congress.
 Real GDP growth averaged 9.8 percent per annum, three-and-half times the global average (2.8 percent) and 50 percent faster than the second-best-performing G20 economy, South Korea (6.3 percent). In the same period, India grew at 6.1 percent, Indonesia at 5.3 percent and Brazil at 2.6 percent. Over 1981-2014, only Equatorial Guinea (a small economy, around USD 15bn in 2014) experienced higher real GDP growth: 16.0 percent in average.
According to the IMF, between 1990 and 2010 for every 1 percentage point increase in China’s growth – if sustained over five years – global growth would benefit from an added 0.4 percentage points.
 China’s growth has historically presented low correlation with global growth. The correlation coefficient between China’s and world’s GDP growth stood at 0.15 before China joined the World Trade Organization (WTO) versus the average correlation of 0.39 for low and middle income countries and 0.80 for the United States. WTO accession increased the correlation, but overall, it remained low at 0.40 versus the average correlation of 0.76 for low and middle income countries and 0.90 for the United States. Trend growth was only mildly affected by the 1997 Asian financial crisis or the 2008 great financial crisis. Similarly, the current deceleration trend owes more to internal dynamics than to global sluggish growth.
 Globally, investment moved in the opposite direction, declining from 26.1 percent in 1978 to 22.2 percent in 2013 (Source: WDI, 2016). In 2015, China’s investment as percentage of GDP stood at 43.3 percent – higher than in 1980 (34.8) but lower than in 2014 (45.9) – and down from a peak of 47.3 in 2011.
 The urbanization rate (urban population as percentage of total population) rose from 17.9 percent in 1978, to 26.4 percent in 1990, 36.2 percent in 2000, 49.9 percent in 2010 and 54.8 percent in 2014. According to the National Bureau of Statistics of China, rural population peaked at 859 mn in 1995, decreasing to 619 mn in 2014 from 790 mn in 1978. In 2014 there were 274 mn rural laborers working in China’s cities, making up about 35 percent of China’s total workforce of around 773 mn. Growth in migrant workers, declined noticeably over the last five years from 5.5 percent in 2010 to just 1.9 percent in 2014.
 Source: Oxford Economics, 2016. In particular: industrial production (CHXIPI.Y) and manufacturing labour cost (CHXWCMF.F).
 In 2014, the proportion of migrant workers employed in manufacturing fell to 31.3 percent from 36.7 percent in 2010. The number of migrant workers in the construction industry by contrast increased to 22.3 percent in 2014 from 16.1 percent in 2010.
 The concept was introduced in 1973 by Edward S. Shaw and Ronald I. McKinnon to define the effect of the creation of captive domestic markets for government debt. Financial repression can be disguised as “macro prudential regulations”, i.e.: the government efforts to mitigate systemic risks in the financial system. See Box. 2.
 In 1979, guided by the leadership of Deng Xiaoping, China started a comprehensive and gradual reform which became crucial for Chinese economic development. Regulating the inflow and outflow of capital has been a cornerstone of China’s development reforms. Capital controls are like a bear trap for savings.
 Households, companies, and banks need to follow strict rules when moving money in or out of the country. The limit for individuals is currently USD 50,000 a year, while corporate investments need government approval.
 People’s Bank of China (PBOC) defines shadow banking as credit intermediation involving entities and activities outside the regular banking system” that serves to provide “liquidity and credit transformation” and “which could potentially” be a source of “systemic risk or regulatory arbitrage. According to IMF estimates, China’s shadow banking accounted for 35.0 percent (CNY 19.9tn) of its GDP in 2014. Types of lending or other financial activities included are trust loans & leases, entrusted loans, bank acceptances, interbank entrusted loan payment, microfinance companies, financial leasing, bond markets and wealth management products among others.
 The skewed interest rates offered by China’s banks represent a tax on depositors and a subsidy for industry. They distort the economy, suppressing consumption, services and private business in favor of investment, industry and the state. And controls on capital outflows prevent sound investments abroad, resulting in large piles of foreign-currency reserves.
 Until 2004 all the major banks in China were 100 percent owned by the state. After 2004 a process called “equitization” gradually transformed them into join-stock corporations albeit maintaining the majority stake of the government.
 In 2013, five big state-owned commercial banks (Industrial and Commercial Bank of China (ICBC), Agriculture Bank of China (ABC), Bank of China (BOC), China Construction Bank (CCB) and Bank of Communications (BOCOM)) accounted for 55.2 percent of the total deposits and 62.7 percent of the total individual savings.
 Over the period 1992-2015, according to Bloomberg, China’s household savings earned in average 2.70 percent (3-months deposits rate) while, according to the IMF, inflation averaged 4.50 percent, de facto reducing the real value of the savings and the purchasing powers of the savers. In October 2015, PBOC lowered the one-year deposit rate from 1.75 percent to 1.50 percent.
 Over the period 1997-2015, according to the IMF, inflation increased from 0.4 percent in 1997 to 1.8 percent in 2015 and, according to Bloomberg, one-year lending rate decreased from 8.6 percent in 1997 to 4.3 percent in 2015, hence real interest rate (one-year lending rate less inflation rate) has decreased from 8.2 percent in 1997 to 2.5 percent in 2015.
 The weakness of social safety nets is the main inhibitor of private sector consumption. The coverage has expanded, but it remains inconsistent, inadequate, inefficient and often riddled with corruption. While rural dwellers receive around CNY 70 a month, urban residents receive between CNY 400 – 500, and public servants two to three times more.
 Since its inception in 1978, the one-child policy has limited the capacity of senior citizens to rely on their children for support. In 2015, the share of China’s population under the age of 24 fell to 30.7 percent from 55.9 percent in 1980, while the share of people aged 60 and up rose to 15.2 from 7.2 in 1980. The urban fertility rate fell from on average 3 per family in the early 1970s to just about 1 in the early 1980s. Intergenerational transfers (family support) are the main source of revenues for more than half of elderly people. Other theories explain high savings through marital status (households with a son would increase savings to improve the marriageability of their son) or income inequality.
 As of September 2015, the government had CNY 21tn (USD 3.3tn, or 32 percent of gross domestic product) in bank deposits. Those deposits have doubled since 2011 and do not include SOE savings. According to the IMF, in 2015, the budget deficit was 2.7 percent of GDP, higher than in 1985 (surplus of 0.9) but down from its peak of 2.9 in 2002. In the same year, the local government gross debt was 43.9 of GDP percent, higher than in 1995 (21.5 percent).
 In recent years, this trend has been reinforced by the ongoing anticorruption campaign. In late 2012, China’s President Xi Jinping, launched an anti-corruption campaign. The campaign faces opposition within the establishment and is being blamed for further pressuring a decelerating economy. According to BNP Paribas, over the past two years the campaign has reduced China’s GDP by 1-1.5 percent per year.
 According to Article 34 of the Guarantee Law of the People Republic of China (1995), the main categories of the eligible collaterals are: i) properties; ii) equipment; and iii) state-owned property at borrower disposal. SMEs however, can seldom provide such collateral to banks.
 Directed credit has been often utilized in the region, and is considered to be one of the most successful policies promoting the industrialization in Japan, South Korea or Taiwan.
 SOB management overlooked SOE NPLs, while private sector NPLs could jeopardize a banker’s career.
 More specifically, financial repression can include measures aimed at: a) creating a captive domestic market for government debt via: i) explicit or implicit ceilings on interest rates; ii) high reserve (or liquidity) requirements combined with the issuance of nonmarketable – i.e.: to be held until maturity – government debt; iii) prohibition of gold purchases and securities transaction taxes; and iv) cross-border capital controls; and b) aligning local banks to government goals via: i) barriers to entry into the financial sector; ii) public control of financial institutions; and iii) directed lending to government entities by captive domestic audiences (i.e., domestic banks, pension funds).
 Gross fixed capital formation (GFCF) refers to the net increase in physical assets (investment minus disposals). It includes land improvements; plant, machinery and equipment purchases; and the construction of roads, railways and the like, including schools, offices, hospitals, private residential dwellings and commercial and industrial buildings. It does not account for the consumption (depreciation) of fixed capital and land purchases.
 Non GDP weighted share of investment over GDP.
 In 2014, after China, Indonesia is the second G20 economy with a larger weight of investments, with GFCF representing 32.6 percent of GDP. China’s GFCF increased from 29.4 percent of GDP in 1978 to 44.2 percent in 2014 while Indonesia’s GFCF increased from 22.3 percent in 1979 (data for 1978 not available) to 32.6 percent in 2014. Globally, investment moved in the opposite direction, declining from 25.0 percent in 1978 to 21.9 percent in 2014.
 In October 2015 the Qualified Domestic Individual Investor program (QDII2) was announced, improving the investment options for ordinary Chinese. Bank deposits frequently pay less than the rate of inflation. As a result, Chinese savings flow into stocks and property, feeding boom-and-bust cycles in local stock and real estate markets.
 Over the past 20 years Chinese banks have offered an average annualized rate of about 2.0 percent on deposits and before the deposit cap removal in October 2015, the banks offered rates below the previous cap of 1.5x on the benchmark deposit rate (on October 23, 2015, the PBOC had cut its one-year deposit rate by 25 basis points to 1.5 percent). Most banks offered rates at 1.1x – 1.2x, and few offered in excess of 1.3x, the pricing was on average 1.4x the benchmark deposit rate across different tenors.
 The government keeps tight restrictions on how pension funds can be invested. China’s cabinet had finalized guidelines in August 2015 allowing pension funds to be invested in higher-return products, including stocks and equities. The funds were previously parked in banks or invested in treasury bonds with low yields.
 According to Bloomberg, the Chinese stock market crash began on 12 June 2015. Within three weeks it had lost 29.0 percent of its value, down to 38.0 by August, mainly due to the unexpected devaluation of the yuan on 11 August 2015 and the slowdown in China’s industrial activity signaling a weaker outlook for the economy. In January 2016, the Chinese stock market experienced a steep sell-off and trading was halted on 4 and 7 January 2016 after the market fell 7 percent.
 China’s property bubble has been growing; according to Bloomberg floor space under construction rose to a record 7,356 mn square meters (sq.m) by the end of 2015, which – at the current speed of sales – will take at least five years to clear. Yet, in January 2016 in cities like Shenzhen, Shanghai, and Beijing prices rose 52 percent, 18 percent and 10 percent respectively over the last year. In smaller cities, prices kept falling, though at a slower pace. For example, in the northeastern city of Shenyang, new-home prices slipped 0.5 percent in January 2016. China’s property investment growth slowed to 1 percent last year, the worst since 1998. Developers are not bidding for new land or starting fresh projects as the inventory mounts.
 In a selection of comparable housing sector bubbles in other countries, the peak residential construction investment as a percent of GDP are: Spain (12.5 in 2006), China (10.4 in 2013), Thailand (9.9 in 1991), Cyprus (9.2 in 2008), Japan (8.7 in 1973).
 In 2009, the government intervened with a stimulus plan worth CNY 4tn (USD 590bn) and bank lending for USD1.4tn.
 To combat the real estate bubble and to limit over-indebtedness of banks, the one-year loan interest rate rose during 2009-2011 – from 5.3 percent to 6.6 – and the required reserve ratio grew from 14.0 percent in 2009 to 21.5 percent in 2011. The minimum down payment to purchase a house rose from 20 percent to 30 percent and since 2011, starting with the second home purchase, the personal down payment had to be equivalent to 60 percent of the sale price. In 2011, Shanghai and Chongqing received authorization to collect a property tax to fight against real-estate speculation.
 Aside from banks, trust companies are the most likely vehicles for the provision of shadow credit. Between 2004 and 2014, trust lending was – by far – the fastest growing form of finance. From end-2005, loans grew by over 26 times to an estimated CNY 5.5tn outstanding by end-2014 and total trust assets were CNY 14tn.
 Shadow banking products satisfied not only financing demands but also investment demands, as retail and institutional investors obtained higher yields from shadow banking products (such wealth management products (WMP) than from banking deposits. These loans do not appear on balance sheet. As of end-2014, CNY 15tn worth of WMPs were held by banks which represented 25 percent of the GDP and 60 percent of them were under trust companies and the remaining largely with financial institutions.
 In 2015, the typical WMP product yield ranged between 4.5 percent and 5.0 percent, with some offering up to 10.0 percent. The government limits the annual yields on savings accounts to 3.0 percent.
 Shadow banking, concentrated outside of the banking system and not yet regulated, is growing rapidly. A key risk of unguaranteed bank wealth management products (WMPs) is the maturity mismatch between most WMPs sold to investors and the assets they ultimately fund. WMPs are often invested in illiquid assets with maturities in excess of one year, while the products themselves tend to have much shorter maturities; around 60 per cent of WMPs issued have a maturity of less than three months.
 In 2013, concerned about the explosion in credit brought about by the 2008-stimulus, the government asked all banks to reduce risk in their balance sheet; however, most of the riskier credit – often to the real estate sector – was repackaged and channeled into the shadow banking sector and resold to investors as wealth management products.
 In January 2014, a trust marketed by ICBC said it likely wouldn’t be able to pay investors back as the CNY 3bn, or around USD 496 mn, trust used its funds to make a loan to unlisted coal company Shanxi Zhen Fu Energy Group, which has since collapsed. In 2014 products worth around USD 126mn issued by Jilin Province Trust failed to repay investors; the trust also made loans to a coal company, Shanxi Liansheng Energy. Xingrun Real Estate in Zhenjiang, Zhejiang left a total of CNY 3.5bn of unpaid debt in 2014.
 China’s RRR is about 17 percent for the country’s biggest lenders and 15 percent for small banks, which is much higher than that in the US (about 10 percent) and Europe (1 percent). A high RRR reduces banks’ ability and willingness to lend to high risk companies like small-and medium sized enterprises (SMEs). These companies are therefore forced to obtain funding through off-balance-sheet activities.
 Margin loan lets one borrow money to invest in approved shares, since using existing cash or shares as security. Since October 2011, margin lending was introduced as a standard program in China, and the China Securities Regulatory Commission (CRSC) lowered the account-opening requirement from 18 months to 6 months and removed the minimum value of cash and stock limit of CNY 500,000.
 The combined market turnover (a ratio measuring how often shares are transferred from one hand to another) of Shanghai and Shenzhen stock exchanges reached USD 380bn on May 28 2015, compared to USD 132bn in the US and USD 9bn in the UK, according to Bloomberg.
 As of December 2015, the CBOE China ETF VIX (the main volatility index) stood at 27.0, 3.9 percent higher than the 2014 level. In December 2015, the standard deviation of the Shanghai composite index was at 39.6 percent, compared to 17.3 percent of 2014. Source: Bloomberg, 2016.
 In 1979, China adopted a policy requiring the Han (the ethnic majority, with over 91 percent of population in 2010) couples to have only one child. According to estimates the policy has prevented over 250mn births. The same law has largely exempted ethnic minorities.
 According to The Economist, in 2013 the working age population declined by 3.45mn. It is to be noted that in the same year the NBS changed the definition of “working age”, from 15-64 to 15-59 years of age.
 United Nations (UN) World Population Prospects: The 2015 Revision. In the 2013 version the takeover was expected to take place in 2028.
 In the 1980s, surplus labor was estimated at around 150 to 200 million workers. Over the last 30 years, 270 million rural workers are estimated to have migrated to cities. In 2010, the pool had declined to around 70 million, or 5 percent of the population. Source: estimates by Knight, Quheng (Chinese Academy of Social Sciences) and Shi (Beijing Normal University), The Economist, 2010.
 A new law to improve the social rights of Chinese workers was approved in 2008, while the system of residency (hukou) will likely be phased out by 2020. Under the current system migrants may not obtain residency status in large cities even after living for 5 years which results in denial of basic rights like health and education for migrant families.
 In December 2014, according to the WSJ, “Directive 43” banned local governments from backing debt issued by local government financed vehicles (LGFV) and to use LGFV debt as collateral in the stock market. In February 2015 these bonds accounted for 34 percent of the USD 2.5tn corporate-bond market. In late 2015, the government loosened the conditions for high credit rating companies to issue debt, requiring simply registration, as opposed to specific approval.
 The joint market capitalization of the Shanghai and Shenzhen stock exchanges rose from USD 1.1tn in 2006 to USD 7.0tn in June 2015, when it reached its peak, and then fell by 18 percent in the second part of 2015. As of 31 December 2015, their combined market capitalization stood at USD 5.7tn, which is 1.2x times of the 2014 level of USD 4.8tn and 12.4x times of the 2002 level of USD 0.5tn, according to Bloomberg.
 The FSB (Financial Stability Board) in its “Global Shadow Banking monitoring report for 2015” estimates that China accounted only for 8 percent of global shadow banking assets. The share of advanced economies is higher at US (40 percent), UK (11 percent) and Ireland (8 percent).
 Over the years, China’s government has launched various schemes to liberalize its capital and financial account, as follows: a) Qualified Foreign Institutional Investor (QFII) Scheme; b) Renminbi Qualified Foreign Institutional Investor (RQFII) Scheme; c) Qualified Domestic Institutional Investor (QDII) Scheme; d) Qualified Domestic Individual Investor (QDII2) Scheme; e) Free Trade Zones (FTZs); f) Shanghai-Hong Kong Stock Connect; g) Mutual Fund Connect.
 Examples are: a) property investment: as of December 2015, property floor space under construction outstripped annual sales by 5.7 times (i.e.: over the same period, the cumulative floor space under construction was 7,356mn sq.m and the floor space sold was 1,285mn sq.m); overall property investment only grew 1 percent annually in 2015 compared to 10.5 percent a year earlier; and b) capacity utilization in the steel sector: between 2011 and 2014 it fell from 81 to around 71 percent. Source: Bloomberg, 2016.
 The incremental-capital-to-output ratio (ICOR), an indicator of the productivity of capital – as it measures the additional units of capital needed to increase output by one unit – has been rising steadily. Estimates coincide on the trend but differ on the magnitude: according to CEIC, the ICOR rose from 3.8 in 1990 to 6.2 in 2012 and 7.1 In 2013. Conversely, the OECD observes an increase from around 3.5 in 2007 to over 5 in 2013. In the same survey, the OECD notes that while the return on capital is still elevated, it has been constantly decreasing since 2006.
 According to different estimates, (Shang 2013, Lardy 2014) SOEs might be receiving between 20 and 36 percent of loans, while they are providing 70 percent of employment and creating 60 percent of GDP.
 IMF’s China art. IV forecasted 9.5 percent growth for China in the 2011-2015 period. In 2012, the average was reduced to 8.5 percent. Growth declined from 9.2 percent to 6.9 percent in that period. The underlying principle of “back to normality” has been resilient. In 2012 The Economist set potential growth of China in the future in the 7-8 percent range. That year, the Renmin University expected growth to go up to 9.3 percent in 2013 (the actual reading was 7.7) and Credit Agricole saw growth in 2014 at 8.5 percent (actual 7.3 percent), and even a year later UBS still expected Chinese growth in 2014 to accelerate from 7.6 percent to 7.8 percent (it fell to 7.3 percent).
 Inertia in macroeconomic variables has been explained in economic theory through a) a signal extraction problem, so that actions react only partially to shifts in fundamentals due to the residual uncertainty or b) sticky expectations, where otherwise rational and forward-looking agents receive information with some delay, among other (Morris, 2006).
 According to IMF forecasts, world real GDP growth is expected at 3.2 percent in 2016, which is 7 basis points higher than the 2014 level of 3.1 percent; 105 basis points higher than the 1980 level of 2.1 percent. Although the growth is expected to improve to 3.9 percent by 2021.