China’s bad dream

Financial Mirror (Cyprus) - - FRONT PAGE -

Since his first ad­dress as China’s pres­i­dent last year, Xi Jin­ping has been es­pous­ing the so-called “Chi­nese Dream” of na­tional re­ju­ve­na­tion and in­di­vid­ual self-im­prove­ment. But the im­per­a­tive of ad­dress­ing the un­prece­dented amount of debt that China has ac­cu­mu­lated in re­cent years is test­ing Xi’s re­solve – and his govern­ment is blink­ing.

The Chi­nese govern­ment’s un­cer­tain abil­ity – or will­ing­ness – to rein in debt is ap­par­ent in its con­tra­dic­tory com­mit­ment to im­ple­ment ma­jor struc­tural re­forms while main­tain­ing 7.5% an­nual GDP growth. Given that China owes much of its re­cent growth to debt-fi­nanced in­vest­ment – of­ten in projects like in­fra­struc­ture and hous­ing, meant to sup­port the Chi­nese Dream – any ef­fort to get credit growth un­der con­trol is likely to cause a hard land­ing. This prospect is al­ready prompt­ing the au­thor­i­ties to de­lay crit­i­cal re­forms.

To be sure, China’s debt/GDP ra­tio, reach­ing 250% this month, re­mains sig­nif­i­cantly lower than that of most de­vel­oped economies. The prob­lem is that China’s stock of pri­vate credit would nor­mally be as­so­ci­ated with a per capita GDP of around $25,000 – al­most four times the coun­try’s cur­rent level.

There are strong par­al­lels be­tween China’s cur­rent predica­ment and the in­vest­ment boom that Ja­pan ex­pe­ri­enced in the 1980s. Like China to­day, Ja­pan had a high per­sonal sav­ings rate, which en­abled in­vestors to rely heav­ily on tra­di­tional, do­mes­ti­cally fi­nanced bank loans. More­over, deep fi­nan­cial link­ages among sec­tors am­pli­fied the po­ten­tial fall­out of fi­nan­cial risk. And Ja­pan’s ex­ter­nal po­si­tion was strong, just as China’s is now.

Another sim­i­lar­ity is the ac­cu­mu­la­tion of debt within the cor­po­rate sec­tor. Cor­po­rate lever­age in China rose from 2.4 times eq­uity in 2007 to 3.5 times last year – well above Amer­i­can and Euro­pean lev­els. Nearly half of this debt ma­tures within one year, even though much of it is be­ing used to fi­nance multi-year in­fra­struc­ture projects.

Mak­ing mat­ters worse, much of the new credit has orig­i­nated in the shadow-bank­ing sec­tor at high in­ter­est rates, caus­ing bor­row­ers’ re­pay­ment ca­pac­ity to be­come over­stretched. One in five listed cor­po­ra­tions car­ries gross lever­age of more than eight times eq­uity and earns less than two times in­ter­est cov­er­age, weak­en­ing con­sid­er­ably these com­pa­nies’ re­silience to growth shocks.

To be sure, China’s sit­u­a­tion is more ex­treme than Ja­pan’s. At its peak, Ja­panese in­vest­ment stood at 33% of GDP, com­pared to 47% in China. This is a sub­stan­tial dif­fer­ence, es­pe­cially con­sid­er­ing that China’s per capita GDP amounts to only 19% of Ja­pan’s at its high­est level, and that its debt has al­ready reached 60% of Ja­pan’s. More­over, the ac­cu­mu­la­tion of debt in China – 71 per­cent­age points of GDP over the last five years – has been far sharper than in Ja­pan, where the debt level grew by only 16 per­cent­age points over the five-year pe­riod be­fore its bust.

That is all the more rea­son to be­lieve that Ja­pan’s ex­pe­ri­ence can pro­vide im­por­tant in­sight into the risks that China faces. Af­ter Ja­pan’s bub­ble burst, an­nual GDP growth, which av­er­aged 5.8% in the four years pre­ced­ing the bust, plum­meted to 0.9% for the next four years. With bad debt left to fes­ter on banks’ bal­ance sheets, growth van­ished and de­fla­tion set in. While pri­vate debt as a share of GDP sta­bilised, pub­lic debt in­creased by 50% in the five years af­ter the bust.

The col­lapse of China’s credit bub­ble would likely cause an­nual GDP growth to drop to 1-2%, on av­er­age, for the sub­se­quent four years, as­sum­ing a 2% an­nual de­cline in cap­i­tal ex­pen­di­ture and a still-re­spectable con­sump­tion-growth rate of 3-5%. Con­sol­i­dated pub­lic-sec­tor debt would rise to 100% of GDP. This is a rel­a­tively mod­est pre­dic­tion. With­out au­to­matic sta­bilis­ers or a strong fi­nan­cial-sta­bil­ity frame­work un­der­pinned by de­posit in­sur­ance, cop­ing with the down­side risks of the po­ten­tially desta­bil­is­ing fi­nan­cial re­forms that the govern­ment is pur­su­ing will be dif­fi­cult enough; a credit shock could prove dis­as­trous. China’s debt tip­ping point is to be found in its mas­sive real-es­tate bub­ble. Ac­cord­ing to the in­vest­ment bank UBS, new ur­ban hous­ing sup­ply has far ex­ceeded mar­ginal un­der­ly­ing de­mand from ur­ban pop­u­la­tion growth. In­deed, al­most half of the for­mal in­crease is not an in­crease at all, but merely recog­ni­tion of ru­ral work­ers who have been liv­ing and work­ing in cities for some time. The im­pact of a sharp de­cline in real-es­tate prices would be far­reach­ing. Af­ter all, prop­erty col­lat­eral is the bedrock of the Chi­nese fi­nan­cial sys­tem, with es­ti­mates of banks’ di­rect and in­di­rect ex­po­sure to real es­tate rang­ing from 66% to 89% of GDP.

Com­pli­cat­ing mat­ters fur­ther is the govern­ment’s lack of op­tions for sta­bil­is­ing prop­erty mar­kets. In fact, a key part of the prob­lem is that China’s re­sponse to cycli­cal weak­ness al­ways en­tails more hous­ing con­struc­tion.

China’s lack of au­to­matic sta­bilis­ers places the ten­sion be­tween re­form ob­jec­tives and growth im­per­a­tives in sharp relief. The only way for the govern­ment to shore up growth in the short run is to pur­sue more debt-driven stim­u­lus, as it did ear­lier this year. But this will also cause China’s debt bur­den to con­tinue to grow, with bad debt in­creas­ingly crowd­ing out good credit.

If China’s lead­ers con­tinue to choose debt-fu­eled growth over re­form, they will only de­lay, and pos­si­bly pro­long, the in­evitable slow­down. That would turn Xi’s Chi­nese Dream into a more elu­sive prospect.

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