China’s credit co­nun­drum

The Pak Banker - - OPINION - Christo­pher Bald­ing

CHINA has two very good rea­sons to slow the gusher of cheap money that con­tin­ues to flood its econ­omy. The first, ob­vi­ously, is to pre­vent the kind of fi­nan­cial im­plo­sion that's struck down sim­i­larly debt-bur­dened coun­tries. The se­cond is just as im­por­tant: to clear out the dead­wood in the world's se­cond-largest econ­omy.

For Chi­nese lead­ers, the need to prop up fal­ter­ing GDP growth out­weighs fears about a rapid buildup in debt. In Jan­uary alone, banks made a record $385 bil­lion worth of new loans, more than 70 per­cent higher than the year be­fore. Debt now tops 230 per­cent of GDP and could reach as high as 300 per­cent of GDP if cur­rent trends con­tinue. Bil­lion­aire in­vestor Bill Gross has joined the cho­rus of voices call­ing this tra­jec­tory "un­sus­tain­able." Even the Bank for In­ter­na­tional Set­tle­ments, a body not known for hy­per­bole, has warned that Chi­nese debt is reach­ing lev­els that typ­i­cally trig­ger fi­nan­cial crises.

The re­cent surge in credit is merely an ex­ten­sion of poli­cies put into place af­ter the global fi­nan­cial cri­sis. To fend off a down­turn, China launched a mas­sive 2009 fis­cal stim­u­lus pack­age fo­cused on in­fra­struc­ture and in­vest­ment spend­ing. Si­mul­ta­ne­ously, pol­i­cy­mak­ers or­dered banks to open the credit spigot. Since Jan­uary 2009, to­tal loans in China have grown 202 per­cent, for an an­nu­al­ized growth rate of 34 per­cent.

Lo­cal gov­ern­ments and busi­nesses alike have been only too happy to par­take in the largesse. The prob­lem is that most of this money has gone into the least ef­fi­cient, most sat­u­rated parts of the econ­omy. No­mura es­ti­mates that 40 per­cent of bank loans to com­pa­nies go to state-owned en­ter­prises, al­though they ac­count for barely 10 per­cent of China's out­put. The money is be­ing used to prop up com­pa­nies that prob­a­bly shouldn't sur­vive: One Chi­nese se­cu­ri­ties firm sug­gests 45 per­cent of new debt is be­ing used to pay in­ter­est on old debt, like us­ing a new credit card to pay off an old one.

Cheap money is also con­tin­u­ing to ex­pand ca­pac­ity in sec­tors that al­ready have too much. There are cur­rently about fourand-a-half years' worth of res­i­den­tial real es­tate sales un­der con­struc­tion. Coal plants, which are cur­rently run­ning at only 67 per­cent of ca­pac­ity, are in­vest­ing in an ad­di­tional $9.4 bil­lion worth of ca­pac­ity in 2015, with a sim­i­lar num­ber ex­pected in 2016. The govern­ment has pledged to slash ca­pac­ity in the bloated steel sec­tor by as much as 13 per­cent by 2020. But given that the in­dus­try is al­ready los­ing about $25 for ev­ery ton of steel pro­duced, those small cuts, even ex­clud­ing ca­pac­ity ad­di­tions, are hardly go­ing to solve the prob­lem.

The govern­ment isn't blind to the dan­gers. Its 2016 eco­nomic plan lists "delever­ag­ing" and ca­pac­ity re­duc­tion as two ma­jor pri­or­i­ties for the year. The cen­tral bank has im­posed lim­its on cer­tain banks that had been a bit too lib­eral in their re­cent lend­ing. But the fact re­mains that the state-owned gi­ants draw­ing the bulk of new lend­ing are also the most po­lit­i­cally well-con­nected. Rather than shut­ting them down and throw­ing po­ten­tially mil­lions of Chi­nese out of work, the govern­ment hopes to keep them afloat while they're merged and over­hauled.

There's lit­tle rea­son to think this plan can suc­ceed. No coun­try with a sim­i­larly rapid rise in debt lev­els has es­caped ei­ther a fi­nan­cial cri­sis, or like Ja­pan, a pro­longed slow­down. Con­tin­u­ing to lend at this pace will only in­crease the ranks of zom­bie com­pa­nies, alive be­cause of govern­ment life sup­port. Slow­ing lend­ing will inevitably mean lower GDP growth, more cor­po­rate bank­rupt­cies and higher un­em­ploy­ment. But it will also re­duce the buildup of risks that are oth­er­wise cer­tain to come due.

At the same time, Chi­nese lead­ers have an op­por­tu­nity to speed along the tran­si­tion to a more dy­namic econ­omy fo­cused more on ser­vices and con­sump­tion than old-line man­u­fac­tur­ing and in­vest­ment. In­stead of spend­ing money bail­ing out dud com­pa­nies, the govern­ment should be di­vert­ing re­sources to star­tups, small- and medium-sized com­pa­nies and other pri­vate-sec­tor busi­nesses with greater growth po­ten­tial. Money should be spent on re­train­ing work­ers to find new jobs in th­ese in­dus­tries, rather than more high­ways and apart­ment build­ings. Com­pa­nies that can't sur­vive with­out ad­di­tional lend­ing should be al­lowed to fail.

The longer China waits, the more in­tractable th­ese prob­lems will be­come and the fewer op­tions will re­main. By any fi­nan­cial met­ric, Chi­nese lead­ers are fall­ing be­hind in their stated de­sire to speed up the process of delever­ag­ing. If they don't speed up, the fi­nan­cial mar­kets may well do the job for them -and a lot less pleas­antly.

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