Bad news from Beijing

Capital flight, at a rate of about $100 billion a month, threatens to deplete China’s hoard of $3.23 trillion in foreign exchange reserves in a couple of years.

Written by Minxin Pei | Published:March 21, 2016 12:00 am
In slightly more than a month, its main stock market index (the Shanghai Stock Exchange) has fallen more than 20 per cent. In slightly more than a month, its main stock market index (the Shanghai Stock Exchange) has fallen more than 20 per cent.

The year of the monkey did not start auspiciously for Beijing. In slightly more than a month, its main stock market index (the Shanghai Stock Exchange) has fallen more than 20 per cent. The Chinese currency renminbi is losing value. Capital flight, at a rate of about $100 billion a month, threatens to deplete China’s hoard of $3.23 trillion in foreign exchange reserves in a couple of years.

Among the factors responsible for China’s economic woes, the most important ones are domestic. Cyclically, the Chinese economy has just experienced one of the world’s largest credit bubbles. The massive creation of credit since 2008 took China’s debt-to-GDP ratio from 125 per cent in 2008 to around 280 per cent. Based on data provided by the Bank of International Settlements (BIS), non-financial private-sector debt as of mid-2015 was 200 per cent of GDP. If one adds sovereign debt (about 40 per cent of GDP) and local government debt (another 30 per cent of GDP, according to Beijing’s estimate in early 2015), China’s total debt-to-GDP is at least 270 per cent, making China the most highly indebted emerging market economy.

Had China used its capital more efficiently during its debt binge, the country would not have been in its current
plight. But like all other countries that gorged on credit during boom, China wasted a substantial chunk of its capital by shovelling investments into real estate, coal mines, infrastructure, steel mills, automobile plants and other capital-intensive industries. The consequence is costly. A colossal real-estate bubble has left ghost cities around the country while massive investment has created overcapacity in most manufacturing sectors at a time when domestic and external demands are both falling.

In a brutal struggle for survival, Chinese firms are engaged in price wars, underselling each other and creating a vicious cycle in which over-indebted zombie firms destroy the profitability of healthier companies. In most countries, a credit bubble of this magnitude alone should be enough to sink the economy. In the Chinese case, its cyclical downturn has been worsened by its longstanding structural imbalances. With investment accounting for nearly 50 per cent of GDP and household consumption under 40 per cent, even a slight decrease in investment activities, traditionally the engine of growth, can have disproportionate repercussions.

Since persistent over-investment has destroyed the return on capital, Chinese firms can no longer afford to pour good money down a rabbit hole. As a result, falling investment is causing the whole economy to stall (investment ratio declined from 48 to 46 per cent of GDP from 2013 to 2014). Bad as it seems, the Chinese economy has yet to bottom out. Most of the painful restructuring has not occurred. Zombie firms are still kept alive by bank loans.  Their inevitable demise will lead to higher unemployment and a considerable rise in non-performing loans. GDP growth
will fall further and Chinese banks, staggering under a mountain of bad loans, will need to be recapitalised.

At the moment, only 2 per cent of their outstanding credit is classified as “non-performing” (a figure nobody really believes). If we conservatively assume that an additional 5 per cent of their loans to Chinese firms and local governments is non-performing, this would imply $1.15 trillion in loan write-offs, dwarfing the amount of the US bank rescue package of $700 billion in 2008. Since Chinese banks cannot absorb such a hit on their capital, the Chinese state will have step in to recapitalise the banking sector, either by issuing bonds or printing money. The former will reduce the credit worthiness of the Chinese state and the latter will further pressure the Chinese currency to depreciate.

For the global economy, China’s looming recession or stagnation is clearly bad news. But the impact of Beijing’s woes
will be felt unevenly and transmitted through different channels. The most direct and destabilising impact is financial contagion. China’s excessive debt and capital flight obviously undermine confidence worldwide. The result so far is a plunge of equity prices around the world and a flight to safe havens. An even more worrisome consequence is competitive devaluation. The consensus in the market is that the Chinese currency has further room to fall. Although Beijing has opted, at least for now, to defend its currency at any cost, it may be forced to capitulate if this effort becomes unsustainable. At the current rate of outflows, the Chinese foreign exchange reserves will fall below $2 trillion in a year, the minimum level of reserves many analysts believe China must maintain to avoid a potential balance of payment crisis and an even more panicky run on its currency.

While financial contagion will hit most economies more or less equally because of the highly integrated global financial system, the fallout from the slowdown in China’s real economy will affect developing countries more than developed ones. It is now clear that fast growth in developing countries in the last decade was chiefly due to China’s demand for commodities. As the Chinese appetite for minerals and energy wanes, the price of commodities is plummeting, bringing down growth in commodity-producing developing countries. Since it is unlikely that Chinese demand for commodities will return to the same high level any time soon, it is almost certain that growth in emerging market economies will languish along with China’s.

For developed economies, the real danger coming out of China is deflation. Although China is an important trading
partner for the US and the European Union (EU), its imports from these two largest economies in the world are less than 10 per cent of the total exports of the US and the EU. Falling demand from China will hurt these economies modestly. But the deflation being exported out of China, most visibly in the steel industry, can devastate industries in developed economies that directly compete against China. If Chinese firms start dumping their excess output on the global market the way their beleaguered steel mills have been doing since last year, deflation could wreck the already-fragile world economy.

The writer is professor of government at Claremont McKenna College and a non-resident senior fellow at the German Marshall Fund of the United States