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Debt troubles within the Great Wall

Is China different? Or must its borrowing binge, like most others, end in tears? This is now a hotly debated topic.

Old residential buildings in central Shanghai are being demolished to make room for skyscrapers. A recent study by the International Monetary Fund argues China may have been over-investing by between 12 and 20 per cent of its gross domestic product, with some of the money spent on real estate likely to have been squandered. Photo: Reuters

Old residential buildings in central Shanghai are being demolished to make room for skyscrapers. A recent study by the International Monetary Fund argues China may have been over-investing by between 12 and 20 per cent of its gross domestic product, with some of the money spent on real estate likely to have been squandered. Photo: Reuters

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Is China different? Or must its borrowing binge, like most others, end in tears? This is now a hotly debated topic.

On one side are those who predict a Chinese “Minsky moment” — a point in the credit cycle at which, as Hyman Minsky foretold, panic grips the financial system.

On the other side are those who insist China’s mountain of debt poses no threat to the planned growth of the economy: The authorities say it will be above 7 per cent and above 7 per cent it will be.

Which side is right? “Neither” is my answer. China will not have a financial meltdown. However, the end of its credit addiction will result in lower growth, properly measured.

Three facts about recent economic developments seem to be quite clear.

First, if you take the official statistics at face value, China’s net exports shrank from 8.8 per cent of gross domestic product in 2007 to 2.6 per cent in 2011.

This was offset by a jump in the share of investment over the same period, from 42 per cent of GDP — already extremely high — to 48 per cent. There are reasons to doubt reported levels of investment, but it is less reasonable to question its abrupt rise.

Second, linked with the rise in the share of investment was an explosion in credit and debt.

The International Monetary Fund (IMF) said by the final quarter of last year, total “social financing” — as the Chinese authorities describe it — had reached 200 per cent of GDP, up from only 125 per cent before the crisis.

Moreover, much of this increase had been outside traditional banking channels. Instead, there has been explosive growth of what one might call a “shadow banking system with Chinese characteristics”.

This does not rely on the complex securitisations or wholesale markets now notorious in the West, but rather, on new intermediaries, such as trusts, and innovative instruments such as “wealth-management products”.

Credit rating agency Fitch reported that credit outstanding to the private sector is now as big, relative to GDP, as it was in the United States in 2007.

Third, China’s growth rate has slowed from 10 per cent or more in the past decade to about 7 per cent in 2012 and 2013. This is still high. But it is not quite as high.

 

IS CHINA OVER-INVESTING?

 

Imagine you were told of an unnamed economy that had soaring investment and credit, but falling growth.

A rising proportion of investment activity was being funded by debt, while at the same time returns were falling. You would surely expect an unhappy ending.

There are those who argue that “this time is different”. Standard Chartered Group CEO Peter Sands has noted several differences from pre-crisis conditions elsewhere. China has borrowed to fund investment, rather than consumption; companies are the main borrowers; and the country is not dependent on foreign lenders. In addition, the yuan is not freely convertible into foreign currency.

The first two points are weak. Minsky’s theory of financial instability was in fact about corporate finance. Moreover, the debts that loomed so large in the US in the 1930s and Japan in the 1990s were also largely corporate. The quality of the investment is what matters and on this, there are reasons for doubt.

A recent study by the IMF argues that China may have been over-investing by between 12 and 20 per cent of GDP. Some of the money spent on real estate and industrial capacity is likely to have been squandered.

The other two points are stronger. Not only is China a net creditor, but it also has exchange controls.

Domestic creditors cannot take their money out of China. If they pull out of one part of the financial system, they will have to put it back into other domestic assets. The People’s Bank of China can deal with any run on it.

Moreover, the IMF has said even China’s “augmented public debt” —which includes spending by local governments that is not always captured in official data — was only 45 per cent of GDP in 2012.

The Chinese government could, beyond doubt, bear any conceivable losses if it wanted to — particularly since, unlike Japan in 1990, China has a relatively undeveloped economy that still possesses good longer-term catch-up potential.

 

REFORM AND REBALANCING

 

Yet, this does not mean all is well. As Herbert Stein, economic adviser to President Richard Nixon, famously remarked: If something cannot go on forever, it will stop.

Credit cannot grow faster than GDP forever, even in China. The question is not whether it will stop, but how and when. The longer this goes on, the greater the risk of a nasty surprise down the road.

Furthermore, some part of the recent growth has almost certainly been an illusion: Investment that does not generate much of a return is in part waste, rather than valuable output, however beneficial its immediate impact on demand may seem to be.

The accumulation of debt is likely to end not with a financial bang, but with a whimper, as growth peters out. IMF said low interest rates for household savers have helped subsidise investment to the tune of about 4 per cent of GDP a year. Small and medium enterprises (SMEs) face a higher cost of capital because of the priority given to larger corporations. These implicit taxes on households and SMEs will probably have to rise, harming the economy, if investment is to be sustained at these exalted levels.

This leaves the Chinese government with an apparent dilemma: Let the debt accumulation continue, creating bigger problems in the future; or implement rapid reform and risk a fall in investment and a bigger unplanned slowdown now. The solution must be a middle way: Accelerate adjustment and reform, while sustaining aggregate demand through monetary and fiscal policies operated by the central government.

China’s ability to postpone a crisis might lead the powers-that-be to prefer the option of adjustment delayed. That could prove a huge mistake. Growth cannot be sustained by increasing indebtedness indefinitely. Reform and rebalancing are essential. From what I heard at the China Development Forum last month, the Chinese authorities understand this. Indeed without these reforms, their plan for liberalising the capital account could be lethal. China can avoid a financial crisis. That is a boon, though it also risks reducing pressure for reform. Yet, reform must come — and the sooner the better. THE FINANCIAL TIMES

 

ABOUT THE AUTHOR:

 

Martin Wolf is Chief Economics Commentator at The Financial Times.

 

 

 

 

 

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