Must China's borrowing binge, like most others, end in tears? This is a hotly debated topic. On one side are those who predict a "Minsky moment" – a point in the credit cycle at which, as Hyman Minsky foretold, panic grips the financial system. On the other are those who insist China's debt mountain poses no threat to economic growth: the authorities say it will be above 7 per cent and above 7 per cent it will be. Which side is right? Neither, is my answer. China will not have a financial meltdown. But the end of its credit addiction will lead to lower growth, properly measured.
Three facts about recent economic developments seem clear. First, if you take the official statistics at face value, China’s net exports shrank from 8.8 per cent of gross domestic product in 2007 to 2.6 per cent in 2011. This was offset by a jump in the share of investment in the same period, from 42 per cent of GDP – already high – to 48 per cent. There are reasons to doubt reported levels of investment, but it is less reasonable to question its abrupt rise.
Second, linked with the rise in the share of investment was an explosion in credit and debt. According to the International Monetary Fund, by the final quarter of last year total "social financing", as Chinese authorities describe it, reached 200 per cent of GDP, up from only 125 per cent before the crisis. Moreover, much of this increase had been outside traditional banking channels. Instead, there has been explosive growth of what one might call a "shadow banking system with Chinese characteristics". This does not rely on the complex securitisations or wholesale markets now notorious in the west, but on new intermediaries, such as trusts, and innovative instruments, such as "wealth-management products". According to Fitch, credit outstanding to the private sector is now as big, relative to GDP, as it was in the US in 2007.
Unhappy ending
Third, China's growth rate has slowed from 10 per cent or more in the past decade to about 7 per cent in 2012 and 2013. This is still high, but not as high. Imagine being told of an unnamed economy with soaring investment and credit, but falling growth; with a rising proportion of investment activity funded by debt, but falling returns. You would expect an unhappy ending.
Some argue "this time is different". Peter Sands of Standard Chartered notes differences from precrisis conditions elsewhere: China has borrowed to fund investment, rather than consumption; companies are the main borrowers; the country is not dependent on foreign lenders. In addition, the renminbi is not freely convertible into foreign currency.
The first two points are weak. Minsky's theory of financial instability was about corporate finance. Moreover, the debts that loomed so large in the US in the 1930s and Japan in the 1990s were also largely corporate. The quality of the investment is what matters, and on this there are reasons for doubt. A recent IMF study argues China may have been overinvesting by 12-20 per cent of GDP. Some of the money spent on real estate and industrial capacity is likely to have been squandered.
The other two points are stronger. China not only is a net creditor but also has exchange controls. Domestic creditors cannot take their money out of China. If they pull out of one part of the financial system, they will have to put it back into other domestic assets. The People’s Bank can deal with any run. Moreover, according to the IMF, even China’s “augmented public debt” – which includes spending by local governments not always captured in official data – was only 45 per cent of GDP in 2012. The government could bear any conceivable losses if it wanted to – particularly since, unlike Japan in 1990, China’s economy is relatively undeveloped and still has longer-term catch-up potential.
Yet this does not mean all is well. As the late Herbert Stein, economic adviser to US president Richard Nixon, famously said: if something cannot go on forever, it will stop. Credit cannot grow faster than GDP forever, even in China. The question is not whether it will stop, but how – and when. The longer this goes on, the greater the risk of a nasty surprise. Furthermore, part of the recent growth has almost certainly been an illusion: investment that generates little return is, in part, waste rather than valuable output – however beneficial its immediate impact on demand seems.
Whimper
The accumulation of debt is likely to end not with a financial bang but a whimper, as growth peters out. According to the IMF, low interest rates for household savers have helped subsidise investment to the tune of about 4 per cent of GDP a year. Small and medium enterprises face a higher cost of capital because of the priority given to larger corporations. These implicit taxes on households and SMEs will probably have to rise, harming the economy, if investment is to be sustained at these exalted levels.
This leaves the Chinese government with an apparent dilemma: let the debt accumulation continue, creating bigger problems in the future; or implement rapid reform and risk a fall in investment and a bigger unplanned slowdown now. The solution must be a middle way: accelerate adjustment and reform, while sustaining aggregate demand through monetary and fiscal policies.
China's ability to postpone a crisis might result in adjustment delayed. That could prove a huge mistake. Growth cannot be sustained by increasing indebtedness indefinitely. Reform and rebalancing are essential. From what I heard at the China Development Forum last month the Chinese authorities understand this. Indeed without these reforms, their plan for liberalising the capital account could be lethal. China can avoid a financial crisis. That is a boon, though it also risks reducing pressure for reform. Yet reform must come – and the sooner the better.
– Copyright Financial Times Ltd 2014
