The political nightmare of a slowing China
The recent financial turmoil in China, with interbank loan rates spiking to double digits within days, provides further confirmation that the world’s second-largest economy is headed for a hard landing.
Fuelled by massive credit growth, the economy has taken on a level of financial leverage that is the highest among emerging markets. This will not end well. Indeed, a recent study by Nomura Securities finds that China’s financial-risk profile today uncannily resembles those of Thailand, Japan, Spain and the United States on the eve of their financial crises.
Certainly, the People’s Bank of China — which engineered a credit squeeze last month in an attempt to discourage loan growth — seems to believe that financial leverage has risen to dangerous levels. The only questions to be answered now concern when and how deleveraging will occur.
At the moment, China watchers are focusing on two scenarios. Under the first, a soft economic landing occurs after China’s new leadership adopts ingenious policies to curb credit growth (especially through the shadow banking system), forces over-leveraged borrowers into bankruptcy and injects fiscal resources into the banking system to shore up its capital base. China’s gross domestic product growth, which relies heavily on credit, will take a hit. But the deleveraging process will be gradual and orderly.
Under the second scenario, the leaders fail to rein in credit growth, mainly because highly leveraged local governments, well-connected real estate developers and state-owned enterprises (SOEs) successfully resist policies that would cut off their access to financing and force them into insolvency. Consequently, credit growth remains unchecked until an unforeseen event triggers China’s “Lehman” moment. Should this happen, growth will collapse, many borrowers will default and financial chaos could ensue.
Two intriguing observations emerge from these two scenarios. First, drastic financial deleveraging is unavoidable. Second, Chinese growth will fall under either scenario.
So, what impact will the coming era of financial deleveraging and decelerating growth have on the country’s politics?
Most would suggest that a period of financial retrenchment and slow GDP growth poses a serious threat to the legitimacy of the Chinese Communist Party (CCP), which is based on economic performance. Rising unemployment could spur social unrest. The middle class might turn against the party. Because economic distress harms different social groups simultaneously, it could facilitate the emergence of a broad anti-CCP coalition.
Moreover, massive economic dislocation could destroy the cohesion of the ruling elites and make them more vulnerable politically. Indeed, members of the ruling elite will be the most immediately affected by financial deleveraging. Those who borrowed recklessly during the country’s credit boom are not small private firms or average consumers, but local governments, SOEs and well-connected real estate developers (many of them family members of government officials).
Technically, successful financial deleveraging means restructuring their debts and forcing some of them into bankruptcy.