Beijing and the bubble

Beijing and the bubble

China's government may be in denial about the credit crisis

China’s government may be in denial about the credit crisis

The short-lived credit crunch and subsequent panic in the financial markets in China have refocused our attention on the perils facing the world’s second-largest economy. At the moment,theories abound regarding the causes of the credit squeeze. Some believe it was a deliberate step taken by the Chinese central bank to rein in runaway credit growth,particularly in the shadow banking sector. Others suspect it was an ill-planned move that frightened the markets but did little to strengthen the credibility of the government (because the central bank quickly backed down and boosted liquidity).

At this point,the most useful thing to do is not to dwell upon the events in June,however interesting they might be,but to examine the consequences of financial deleveraging in China. The unambiguous signal from the crisis in June is that China’s credit bubble is bursting and,as a result,the country will go through a period of painful financial deleveraging and slow growth.

Until recently,most analysts of the Chinese economy have overlooked the role of the massive expansion of credit in boosting China’s investment-driven growth. To give you some idea about the extent of the credit bubble in China,just take a look at one figure. Total credit was 115 per cent of the GDP in 2008; today it is estimated to be 173 per cent of the GDP. As in all credit bubbles,most of the new loans have gone to risky borrowers,both through the state-owned banks and unregulated shadow banking sector. The biggest beneficiaries of the credit explosion are state-owned enterprises,local governments and real-estate developers. They have put borrowed money into projects of dubious financial viability,such as excess manufacturing facilities,infrastructure and speculative real estate. When the credit frenzy was going on,they did very well. But today,when growth is slowing and the credit bubble has reached a dangerous level,they are feeling the pain.


Even if you have little sympathy for this group,you should be very worried about two issues connected to China’s credit bubble.

The first is regarding the solvency of the banking system and the risks of a full-blown financial crisis. Thankfully,given the nature of the Chinese banking system,which is essentially owned by the state and has sovereign guarantee,a total collapse of this system can be ruled out. Of course,technically speaking,Chinese banks may have bad loans that exceed their capital and are insolvent. In reality,because the government owns and controls the banks and maintains relatively effective capital control,a quick and complete financial meltdown is unlikely to happen. The government can force banks to lend to each other. The central bank can keep the printing press running 24×7. And if recapitalisation of the banking system is needed,Beijing can move the bad assets off the balance sheet or use a combination of fiscal injection and inflation to write off the massive bad loans.

However,even if Beijing dodges one bullet (a collapse of its banking sector),it is unlikely to dodge another — a significant deterioration of growth for an extended period of time.

What we know now about the Chinese economy is that it is fuelled by investment growth,which is in turn driven by credit growth. Since credit growth is about to turn into retrenchment,investment is certain to decline,thus bringing down growth as a whole.

Optimists tend to view slowing growth in China as a linear process,projecting a gradual decline,but no abrupt collapse. Their favoured metaphor for the Chinese economy is that of a speeding train,which can be slowed down without crashing.

But there is a more pessimistic perspective. Martin Wolf,chief economics commentator of the Financial Times,recently compared the Chinese economy to a jetliner and warned that once growth falls to a certain rate,the economy will be stalled and plunged into a downward spiral,just like a jetliner.

This sobering analogy provides a more insightful way of understanding the consequences of financial deleveraging in China because it points to the interconnected nature of the various components of an investment-driven economy (investment has been over 45 per cent of the GDP in China for years). Reducing credit and cutting investment will create simultaneous shocks throughout the economy. On the financial side,excessive manufacturing capacity and infrastructure projects built on the assumptions of future high growth will not be able to service their debts (debt repayments are expected to rise dramatically because of the three to five year maturity terms of new loans). Large-scale default will further depress bank lending because banks with a mountain of bad credit on their books are unwilling to make more loans.

The effect of financial deleveraging on the real economy is likely to be just as devastating. The demand for machinery,labour,steel and practically everything else will contract drastically if investment growth falls below a certain level,creating a vicious cycle and worsening the problem of excess capacity.

How China’s new leadership will deal with this nightmarish economic scenario remains unknown. At the moment,the conventional wisdom is that the new leadership is not unduly alarmed. Instead,they seem to be willing to endure short-term pain and tolerate slowing growth. They apparently understand that debt-fuelled growth is not only ultimately unsustainable but will also lead to a much bigger disaster when the bubble bursts. According to this sanguine interpretation,Beijing is merely biding its time. It is waiting for the economic conditions to worsen to such an extent that it can use the crisis to push through very painful reforms.

However,there may be another, less reassuring answer. When we examine Beijing’s response to the persistent growth slowdown since last year,we actually do not detect significant policy changes. In fact,credit growth has maintained the same pace. There is a distinct possibility that China’s new leaders may not know what to do about the bursting credit bubble. The task of financial deleveraging is very complex. Resistance from vested interests is strong (because many leveraged borrowers can be wiped out during deleveraging). The government itself may be in denial.

Fortunately,we don’t have to wait very long to find out whether Beijing gets it or not. The Communist Party of China’s Central Committee will convene its third plenum in the fall,when a comprehensive economic reform package is supposed to be unveiled. The content of this package will tell us a lot about the new leadership’s resolve to restructure the Chinese economy and tolerance of the resulting pain. Until then,we should remain cautiously pessimistic.


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