The Flailing Dragon
Paras Aggrwal
The Flailing Dragon
Of the many things that are worrying investors around the world, from tumbling oil prices to the spectre of recession and deflation in Europe, one of the most important, and least understood, is China’s debt. China has cut its growth target for 2015 to 7%, which would be the slowest expansion in more than two decades. Data this week show it will be a stretch to hit even that. This might not seem much to fret about. Even at its subdued current rate, China's growth is still the envy of most countries, but the slowdown is cause for concern. China is faring worse than many had expected. Its deceleration is one of the main reasons for the sell-off of global commodities from iron ore to coal over the past two years and there are fears it could yet turn uglier. On a basic level, it was inevitable that the Chinese growth rates of the past three decades, which averaged 10% a year, would wane. The law of large numbers (financial please!) applies to nations as well as to companies.
China’s working-age population peaked in 2012. Investment also looks to have topped out (at 49% of GDP. Finally, China’s technological gap with rich countries is narrower than in the past, implying that productivity growth will be lower, too.
The single most important development has been its credit binge. Total debt (including government, household and corporate) has climbed to about 250% of GDP. The precipitous rise began with China’s gargantuan stimulus in response to the global financial crisis in 2008. Its total debt-to-GDP ratio increased faster than that of any other big country during that time. Similar rises preceded banking crises in much of Asia in 1997 and in America more recently. Little wonder that financial fragility “ is seen as the biggest macro risk to China, if not the global economy ”, according to Standard and Poor’s.
Yet a sudden collapse is most unlikely. The same thing that got China so deep into debt is what keeps it from blowing up: state control of the financial system and the perception, often substantiated, of government backing for debts. Instead, the biggest risk is complacency: that China’s officials do too little to clean up the financial system, weighing down its economy for years with zombie firms and unpayable loans.
Half of China’s debt is owed by companies, and most of that, in turn, is owed by state-owned enterprises and property developers. As the economy slows and housing prices fall, many of these loans will prove unpayable. Banks report that bad loans are just 1% of their assets and their auditors insist that the banks are not lying, but investors price banks’ shares as if the true level is closer to 10%.
Even if a huge swathe of loans go bad, the consequence is unlikely to be a Lehman-style financial collapse. For that, thank the Chinese regime’s vice-like grip on its financial system. Most lending is by state-controlled banks, much of it to state-owned companies. If it faced an economy-wide credit crunch, the government would (as it has in the past) simply order banks to lend more. At the same time the country’s vast foreign-exchange reserves mean China need not worry about a sudden drying up of foreign capital, the main cause of many other emerging-economy crises.
This combination of control and buffers gives China the time and headroom needed to tackle its debt problem. Unfortunately, it has also bred complacency. After all, officials began to talk about tackling debt in 2010. They have taken a few baby steps towards cleaning things up: a new budget law, taking effect next year, gives central authorities more power to oversee local governments borrowings. But, in practice, too many officials are content to see bad loans rolled over; too many prefer bail-outs to defaults. Earlier this year, amid much hoopla, Chaori Solar was the first Chinese company to default on a bond. This month its creditors were bailed out.
This process—extending credit to failing and inefficient firms—creates a slow-burn debt crisis, marked by opacity and a misallocation of capital. Japan provides a depressing precedent. It failed to clean up after its asset bubble burst in the early 1990s, preferring to pretend that firms could pay their debts and banks were solvent. The result was zombie firms, ghostly banks and years of stagnation and deflation.
Beijing’s officials vow they will not repeat Japan’s malaise. To do that they must hold their nerve and let firms fail: a culture of bankruptcy should replace the lifelines and “evergreening” of useless loans. As long as investors think the state will cover their losses, they will plough money into dodgy schemes—and the problem will grow. Not only will that be a huge waste of money; even mighty China cannot cover losses for ever.
Xi Jinping, China’s president has placed less emphasis on growth and faster structural reform. The central bank has been hesitant to ease monetary policy. Changes to fiscal rules have made it harder for local governments to spend money. With consumer-price inflation running at a five-year low of 1.1% and producer prices deep in deflation, there is a case to be made that China’s economy, restrained by the government, is performing below its potential. The good news is that neither the cyclical nor the policy explanations for China’s slowdown are permanent. As the cycle turns and policy changes, the outlook should improve. But the structural shifts in the Chinese economy are a different story. They will cap any rebounds. Double-digit growth is most certainly a relic of China’s past.