The Great Debtscape
Why China's economy is not going to be swallowed alive by its massive deficit.
Since the global financial crisis of 2008, China has persistently defied skeptics who warned of a severe recession or financial collapse. Today the skeptics are louder than ever, as they point to the difficulty Beijing will face in maintaining economic growth even as it tries to discipline an unruly financial sector and cut back on debt. "China's debt-fueled boom is in danger of turning to bust," Ruchir Sharma, head of Morgan Stanley Investment Management's emerging-markets team, warned on Jan. 27. "Only five developing countries have had a credit boom nearly as big as China's. All of them went on to suffer a credit crisis and a major economic slowdown."
Since the global financial crisis of 2008, China has persistently defied skeptics who warned of a severe recession or financial collapse. Today the skeptics are louder than ever, as they point to the difficulty Beijing will face in maintaining economic growth even as it tries to discipline an unruly financial sector and cut back on debt. "China’s debt-fueled boom is in danger of turning to bust," Ruchir Sharma, head of Morgan Stanley Investment Management’s emerging-markets team, warned on Jan. 27. "Only five developing countries have had a credit boom nearly as big as China’s. All of them went on to suffer a credit crisis and a major economic slowdown."
But a glance at China’s recent history shows why prophecies of doom for the world’s second-largest economy should be treated with suspicion.
The first worry after the global crisis was that the country would be unable to wean itself of its addiction to exports. Exports had helped China’s economy grow, but fed global instability because of the large trade deficits countries like the United States had to run to offset China’s huge surpluses. Yet in the past five years, China’s export growth has slowed into the low single digits, the country’s share of global exports has stabilized, and the trade surplus has shrunk from 8 percent of GDP to a more sustainable 2 percent.
The next concern was that China would not be able to kick its reliance on infrastructure spending. To maintain economic momentum amid the export slowdown, Beijing authorized local governments to jack up investments, mainly in municipal and transport infrastructure. This drove up the investment-GDP ratio to 47 percent, several points higher than the previous peaks achieved by Japan and South Korea, the other investment-intensive East Asian economies, in similar periods of economic development. Yet in the past two years, infrastructure spending has slowed dramatically, as Beijing has tried to rein in local governments. China’s economic growth now relies as much on consumer spending — which continues to grow at 7 to 8 percent annually in inflation-adjusted terms — as it does on investment.
In short, over the past five years China has rectified one of its famous "imbalances" — excessive reliance on external demand — and made a good start on fixing the other (excessive reliance on investment spending). But a growing chorus of observers views China’s economic future with trepidation. In mid-January, Ray Dalio, who runs Bridgewater Associates, the world’s biggest hedge fund, declared that China was a bubble. And earlier that month, Patrick Chovanec, a well-known China bear, warned that "China’s leaders are riding a runaway train that they don’t quite know how to stop."
These worries are plausible. There is no question that China’s economy has slowed substantially. From an average rate of more than 11 percent in the last decade, growth is now running at around 7.5 percent, and a further slowdown in the next couple of years is likely. Second, since the global crisis, China’s authorities have supported growth by permitting a huge increase in debt. From 140 percent of GDP in 2008, the nation’s gross debt soared to 210 percent in 2013. Much of that new debt financed infrastructure projects by local governments, and capacity expansions by the state-owned companies that provided the goods and services necessary for those projects. While a lot of that infrastructure will prove economically beneficial in the long run, in the short term it will generate financial losses. The big questions for China over the next two years are, can it get its debt under control, and, if so, how much of a toll will that take on economic growth?
It is perfectly reasonable to worry that the cost of reining in runaway debt will be another big growth slowdown. It is also reasonable to worry that as Beijing tries to solve the debt problem, the risk of a major financial accident will go up. Since April, the Chinese monetary authorities have tried to curb lending by raising short-term interest rates and imposing more stringent controls on the non-bank "shadow finance" sector. The sector, which includes lightly-regulated finance companies that offer depositors high returns by investing in risky assets, has been responsible for much of the increase in borrowing since 2011. As a result of these new government controls, funding costs for companies and financial institutions are two or three percentage points higher than they were just six months ago, and year-on-year growth in total credit has slowed from 23 percent to less than 18 percent.
These are necessary measures, but they will exact a price. While local governments will be allowed to roll over loans that they are unable to repay, cash-strapped companies probably will not. Corporate bankruptcies will rise, and this in turn could precipitate defaults in the so-called wealth-management and trust products that provide the funding for many "shadow" loans. Wealth-management and trust products offer investors much higher rates of return than ordinary bank deposits — anywhere from 5 percent to 15 percent. Unlike bank deposits (which are not formally insured but enjoy a strong implicit guarantee from the government), these products are explicitly not guaranteed either by the government or by the financial institutions that sell them. But many investors assume that the government will bail them out — so defaults could cause a crisis of confidence in China’s financial system.
These risks are not simply hypothetical. For weeks, investors have anxiously watched as China Credit Trust, a shadow lender, has worked furiously to avoid default on a $496 million trust product, maturing on Jan. 31, that is built around a loan to a coal-mining magnate in central China who is under arrest. A last-minute deal preserved investors’ capital, though not the interest. But it is very possible that some other large-scale trust or wealth-management product will default this year, sending shock waves through the financial system.
Yet despite these undoubted risks, the doomsayers are likely to be disappointed again, and China will manage to avoid both a financial crisis and a severe recession. Instead, it will probably succeed in slowly bringing its debt problem under control, and GDP growth will settle at a slower — but still more than respectable — pace of 6-7 percent annual growth over the next three years.
One cause for optimism is that the government of President Xi Jinping, which took power about a year ago, is clearly committed to a sustained policy of tighter money and slower but higher-quality growth. Another is that the systemic risks of a wealth-management or trust product default can be contained, because these products still account for less than 15 percent of the funding base of China’s financial system — the rest comes from stable bank deposits.
Most important, the pessimistic view underestimates the flexibility and dynamism of China’s growing private sector. It is this dynamism that has enabled China to absorb the serial shocks of a global liquidity crisis, a sharp decline in export growth, and the more recent slowdown in infrastructure investment, while still maintaining one of the world’s fastest economic growth rates. This dynamism is reflected in the small-cap ChiNext stock market in Shenzhen, which was one of the world’s best-performing stock markets in 2013 with a gain of 83 percent — compared to an 8 percent decline in the Shanghai stock index, which is dominated by state-owned firms. And it shows up in the spectacular performance of Chinese Internet companies, which despite the constraints of government censorship have created one of the world’s biggest and most vibrant markets for e-commerce, social networking, and online gaming. Betting against the power of China’s entrepreneurial spirit has been a losing wager for the last three decades. The odds are it will continue to be a bad bet for several more years to come.
Arthur R. Kroeber is managing director of GaveKal Dragonomics, an independent global economic research firm, and editor of its journal, China Economic Quarterly.
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