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.

By definition, such people have the political wherewithal to mount a fierce fight to preserve their wealth. But, given the huge size of the credit bubble and the enormous amounts of money needed to recapitalise the banking system, only some of them will be bailed out. Those who are not will naturally harbour resentment towards those who are.

Slower GDP growth undermines elite unity according to a different political dynamic. The current Chinese system is a gigantic rent-distributing mechanism. The ruling elites have learnt to live with one another not through shared beliefs, values or rules, but by carving up the spoils of economic development.

In a high-growth environment, each group or individual could count on getting a lucrative contract or project. When growth falters, the food fight among party members will become vicious.

The people who should be most concerned with financial deleveraging and slower growth are President and CCP General Secretary Xi Jinping and Prime Minister Li Keqiang. If the deleveraging process is quick and orderly, they will emerge stronger in time for their reappointment in 2017.

Mr Xi and Mr Li are inseparably linked with the CCP’s promise of economic prosperity and national greatness, embodied in the official catchphrase, “China dream”. What, then, will they do when faced with a political nightmare? PROJECT SYNDICATE

ABOUT THE AUTHOR:

Minxin Pei is Professor of Government at Claremont McKenna College and a non-resident senior fellow at the German Marshall Fund of the United States.