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84 Deleveraging, What Deleveraging
now than in 2009. This consideration, coupled with the evolution of the debt-to-
GDP ratio, calls for an improvement in fiscal policy rather than fiscal expansion.
The political class has much work to do in making the tax system more rational,
disciplining tax expenditures, differentiating between the current and capital
budgets, and making entitlements generationally fairer.
As for the Eurozone, the new fiscal framework provides an anchor for mediumterm
fiscal stability, while its focus on the underlying structural fiscal position
provides some flexibility to enable countercyclical short-run fiscal management.
However, this requires European and national fiscal policymakers to strike the
right balance between short-run and medium-run fiscal objectives, which is
not easy to pull off, especially given the level of uncertainty about the path for
potential output.
Fiscal expansion in China during the crisis has taken the form of off-budget
spending by local government, financed by an expansion of bank and non-bank
credit. This report discussed the rise in local government debt in Chapter 4 and
stressed that the country is still leveraging up. The government is clearly facing
the challenge of a slowing economy coupled with a huge surge in debt overhang
that poses contingent fiscal risks.
Issue 3. Recapitalisation of banks and the sequence of policies
Bank leverage is a key factor in financial crises. When a crisis erupts, the choice
is between early action on recapitalisation or procrastination. As highlighted
in Chapter 4, the lesson from the Eurozone and the US experiences is that
procrastination must be avoided; timeliness and the sequence of policies matter.
The delayed policy action in relation to the recapitalisation of banks in the
Eurozone was an act of procrastination that kept insolvent institutions alive.
Procrastination, while delaying the deleveraging of the banking sector, did
not help to avoid a credit crunch. On the contrary, poorly capitalised banks
decreased the amount of credit to the real economy, since banks changed the
composition of their assets from loans to government bonds. This happened in
a context in which fiscal policy was unsupportive while monetary policy became
progressively less effective. Once liquidity issues became less relevant, solvency
problems in a large part of the European banking sector persisted and became
even worse as a consequence of the second recession. The long-term repo loans
at a fixed rate (LTRO) implemented by the ECB, although essential to preventing
a meltdown of the banking system, were unable to stimulate banks to increase
credit to the real economy since they were used by banks mainly to purchase
government bonds. The credit restriction was aggravated by a de facto restriction
in monetary policy since 2013 when banks started giving back those loans,
thereby inducing a renewed shrinking of the ECB balance sheet at a time when
the Fed was expanding its assets under the impulse of its QE3 programme.
The US and European experiences with repairing troubled banking systems
provides food for thought for Chinese policymakers who must choose between
pre-emptive measures to address excess leverage in the financial sector or delaying
action at the current juncture. This decision is made more complicated by the