China’s credit conundrum

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.