Ef­fects of China’s Fail­ure to Re­form

Enterprise - - Analysis -

The surge in trad­ing on China’s com­mod­ity ex­changes is the lat­est ex­am­ple of spec­u­la­tive frenzy in an econ­omy awash with credit. From the rise of shadow bank­ing to real es­tate bub­bles and Au­gust’ stock mar­ket crash, reg­u­la­tors have strug­gled to con­tain the ex­cesses re­sult­ing from Bei­jing’s habit of sup­port­ing growth through debt-fu­elled stim­u­lus. The rush into met­als mar­kets fol­lows record credit ex­pan­sion of more than Rm­b6tn in the first quar­ter, en­gi­neered by of­fi­cials to pre­vent a sharp slow­down in the world’s sec­ond­largest econ­omy.

Such episodes are a grow­ing con­cern for in­ter­na­tional in­vestors. As China’s role in the global fi­nan­cial sys­tem grows, so too does its abil­ity to trig­ger tur­bu­lence in global mar­kets. How­ever, it is easy to crit­i­cise Bei­jing for re­sort­ing once again to credit cre­ation to pump up growth. It is less easy to come up with an at­trac­tive al­ter­na­tive for pol­i­cy­mak­ers.

The risks of China’s vast debt pile are ap­par­ent. A to­tal debt load equiv­a­lent to some 240 per cent of gross do­mes­tic prod­uct - far higher than most emerg­ing mar­kets - is clearly un­sus­tain­able in the long term, es­pe­cially since a sig­nif­i­cant pro­por­tion is held by loss mak­ing state-owned en­ter­prises in sec­tors suf­fer­ing from chronic over­ca­pac­ity. Even more wor­ry­ing is the speed at which debt has ac­cu­mu­lated - with credit cre­ation ac­cel­er­at­ing even as eco­nomic growth has slowed.

Yet in­vestors clearly find these risks less fright­en­ing than an im­mi­nent prospect of the econ­omy crash­ing and the cur­rency plung­ing - the fears that sent global mar­kets into a tail­spin at the start of the year. Bei­jing’s ac­tions since Jan­uary 2016 have cast doubt on its com­mit­ment to dif­fi­cult eco­nomic re­forms, but they have also helped to sta­bilise the ex­change rate and led to a wel­come pick-up in in­dus­trial prof­its.

More­over, the risk of a full-blown fi­nan­cial cri­sis seems lim­ited. China’s over­all debt level is less alarm­ing in the con­text of the coun­try’s largely closed cap­i­tal ac­count, its high sav­ings rate - which means that house­holds fi­nance lend­ing to cor­po­rate en­ti­ties- and the econ­omy’s

growth po­ten­tial. There is also con­sid­er­able scope for the govern­ment to shift cor­po­rate debts (which in prac­tice of­ten re­late to state-owned com­pa­nies or lo­cal govern­ment) on to its own bal­ance sheet, which re­mains ro­bust, backed by still-vast of­fi­cial re­serves.

How­ever, this will merely de­fer the prob­lem, al­beit for some years, un­less China comes up with a com­pre­hen­sive plan to tackle the cor­po­rate sec­tor’s bad debts. As the In­ter­na­tional Mon­e­tary Fund has warned, the govern­ment’s cur­rent pro­pos­als for fi­nan­cial re­struc­tur­ing of non-per­form­ing loans (through debt­for-eq­uity swaps and se­cu­ri­ti­sa­tion) will be in­suf­fi­cient, and pos­si­bly coun­ter­pro­duc­tive, un­less it also tack­les the un­der­ly­ing need for in­dus­trial re­struc­tur­ing, in­clud­ing in po­lit­i­cally sen­si­tive sec­tors.

Re­bal­anc­ing China’s econ­omy is a Her­culean task and it is almost in­evitable that stim­u­lus poli­cies will con­tinue for the fore­see­able fu­ture as au­thor­i­ties try to man­age the process. What is im­por­tant is to en­sure that this is more prof­itably em­ployed. The au­thor­i­ties re­flex has too of­ten been to prop up zombie com­pa­nies in sec­tors dogged by over­ca­pac­ity, with ef­fects on in­dus­trial ri­vals across the world. Yet in­vest­ment is still needed in health, ed­u­ca­tion, ur­ban hous­ing and trans­port and an enor­mous en­vi­ron­men­tal clean up. In the most be­nign sce­nario, it will still take the best part of a decade to reduce China’s debt bur­den to a more sus­tain­able level. In the mean­time, the rest of the world can ex­pect to feel the ef­fects of China’s fail­ure to re­form and re­bal­ance its econ­omy ear­lier.

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