Great fall of China coming

Posted by in Development, Economics

The verdict of top China economists is unanimous: there is a debt crisis, there are no signs of policy renewal, and a recession is almost inevitable — either sharp and possibly calamitous, or drawn out like Japan’s.

None is willing to punt on the timescale, but all believe this will happen within the medium term — by 2020 or a little after — though not in the next couple of years. For now, on the streets, life looks the same. But it can’t last.

Debt growth has been outpacing gross domestic product growth for years, with its numbers stepping up a year ago, and that gap will widen as the government has to heap ever more stimulus on the economy in order to hit its 6.5-7 per cent growth target — like throwing more and more kindling on to a fire to keep it alive.

Outstanding loans now stand at a record high of more than 200 per cent of gross domestic product, almost double the figure in 2008. Total net debt is estimated at about $35 trillion, borrowed both within China and from overseas. China’s debt bubble — the build-up in unproductive loans — has already accelerated past the US 2007 subprime bubble numbers.

Jonathan Anderson, the principal of Emerging Advisors Group, says: “At the current rate of expansion, it is only a matter of time before some banks find themselves unable to fund all their assets safely. “At that point, a financial crisis is likely.”

The danger posed by China’s corporate debt, on which billions of further stimulus dollars are still being heaped month by month, has led to changed opinions, and to a great convergence among economic analysis for the first time in decades. Until this year, economic experts on the country were riven between “China bulls” and “China bears”. That divide has now disappeared.

Australia has tended to look at China through a very partial lens, focused principally on its resources appetite, and on its GDP growth figure. The bigger picture has begun emerging only gradually for Australians, as the free-trade agreement multiplies the opportunities for engaging with the broader Chinese economy.

One of the obstacles to a deeper understanding has been the inclination of an influential Australian cohort to presume an impervious competence on the part of Chinese policymakers. Such trust in Communist Party management is regularly deployed in Australia as an answer to the many growing concerns about the economy — with consumer spending, employment and industrial activity all declining while share prices are flat and domestic corporate bond defaults are on the rise.

Optimists refer to Chinese exceptionalism — though such claims when made previously about nations or corporations have inevitably in time un­ravelled.

Faith in China’s economic leadership capabilities appears stronger in Australia than in China itself, where President Xi Jinping appears to be driving economic policy yet seeks a cap­acity to spread the blame to other leaders if outcomes continue to deteriorate — which he did, via a front-page article in May in People’s Daily, under the guise of an at-first-mysterious “authoritative figure”.

The mismanagement of the stockmarket plunge last year, and of the currency rate change, have underlined concerns about whether China’s increasingly large and complex economy has grown beyond the ability of a tiny group, or a single “core” figure, to direct.

The international ratings agencies led by Moody’s and Standard & Poor’s have since the global ­financial crisis been criticised for pulling their own punches due to a desire to ingratiate themselves with sovereigns.

Both have, however, felt forced to brave the criticisms inflicted from Beijing as in the past few months they have downgraded their China outlook ratings from stable to negative.

Moody’s gives three chief ­reasons:
“The ongoing and prospective weakening of fiscal metrics, as reflected in rising government debt and in large and rising contingent liabilities on the government balance sheet.
“A continuing fall in reserve buffers due to capital outflows, which highlight policy, currency and growth risks.
“(And) uncertainty about the authorities’ capacity to implement reforms — given the scale of reform challenges — to address imbalances in the economy.”

It says: “The very rapid increase in investment by state-owned enterprises was maintained, at 23.5 per cent year-on-year, in the first half of the year — with such intensified leverage complemented by falling profits.”

China could grow out of its debt problem, Moody’s says. But that would require “substantive economic reform and market liberalisation, which we believe is unlikely at present given slowing growth momentum”.

S&P warns that “China’s opaque and ballooning corporate debt” will rise from 35 per cent to 43 per cent, or $43 trillion, of total global corporate outstanding debt by 2020.

The country’s low transparency and restricted flow of information, it says, robs it of the usual checks and balances, and can lead to the misallocation of resources. Its research on the top 200 Chinese corporates concludes that leverage has reached “a critical level”. The overall ratio of debt to earnings before interest, tax, depreciation and amortisation is now above five times, “the weakest level for our assessment of financial risks”.

One of Asia’s leading brokerage and investment groups, CLSA, says China’s bad debts are reaching “crisis level”.

Research by the company’s head of China-Hong Kong strategy, Francis Cheung, shows China’s non-performing loans at up to 19 per cent of bank assets, way above the official figure of 1.6 per cent and the global average of 4.5 per cent. Most of the bad debts are attributed to loss-making companies.

Yet the government is injecting massive new stimulus into the economy at the same time, under pressure from unemployment as manufacturing jobs contract, from bond defaults, and from slowing GDP growth as foreign direct investment falls in key sectors, and even property turning negative for the first time in years.

China’s banks — almost all state-owned, but listed in Hong Kong and elsewhere — could need to raise funds equal to 15 per cent of GDP, Cheung says, in order to resolve through full provisioning their bad debt headache.

He says: “If your cash flow can’t pay your interest expense, I consider that a bad debt, you’re essentially a loss-making company.” But this is not yet “bad” enough to be classified as such in China.

The CLSA research shows “shadow financing” — banks using off-balance-sheet lending and generally “getting round regulations” — reaching 59 per cent of GDP, with associated bad debts costing 4 per cent of GDP.

Prominent Chinese economist Ma Guangyuan warns that, “as revealed by (People’s Bank of China governor) Zhou Xiaochuan, the biggest risk to China’s economy is not the property market or government debt, but the heavy debt of companies”.

He says that “under the dual pressure from overinvestment and a slowing economy, many companies have failed to pay bank loans since last year. As a result, bad debts have increased continuously for 10 quarters”. “The proportion of non-financial debt to GDP has risen from 100 per cent before 2008 to 250 per cent today — and threatens to trigger a systemic problem for the economy.”

As such views multiply, national news agency Xinhua has attempted to silence them, issuing a stern warning last week that “economists who are downbeat do not deserve to live in such a prosperous land”.

But the warning voices are still multiplying. One of China’s best known economists, Shanghai-based Andy Xie, formerly of the World Bank and Morgan Stanley, told Marketwatch a few days ago that China is “riding a tiger and is terrified of a crash. So it keeps pumping cash into the economy. It is difficult to see how it can avoid a crisis.”

The government’s dominance of the economy is counter-productive: “The communist party,” Xie says, “isn’t compatible with the future of China.”

The leadership team led by Xi Jinping, who chairs the economic reform commission, won widespread applause with its ambitious “third plenum” rhetoric for the economy, that included giving the market a “decisive role”.

But there have been only modest reforms in the three years since then, during which the state sector has been lionised. The reform wing of the party has been ­silenced, its leading magazine Yanhuang Chunqiu (China Through the Ages), being closed this week following a purge of its staff.

The government had announced it would drive a restructuring from a focus on exports and investment towards consumption and services.

But progress on this front has been slow and limited. And with a watershed five-yearly national congress of an increasingly tetchy party taking place in 14 months, the current settings appear locked in, including the ambitious growth target.

Investment remains the dominant growth driver, accounting for 46 per cent over the past five years, while consumption, having at first risen, is now falling back.

Arthur Kroeber, the Beijing-based founder of GavekalDragonomics and author of a new Oxford University book China’s Economy, has been viewed as an exceptionally scrupulous and fair analyst, usually portrayed as a China bull, but is today to be found in the camp of those anxious about the economy.

He says: “Vigorous policy in the next few years could arrest the rise of leverage and enable growth to stabilise at around 5 per cent by 2020.”

This would involve shutting down or privatising the least productive state-owned enterprises — “cutting the state sector roughly in half” — opening up protected service sectors to private and foreign competition, and liberalising the financial system “so that it reliably channels credit to the most productive firms”.

But, he adds — and this is a very big but — “the problem, from the party elite’s point of view, is that these reforms would require that the regimen surrender much of its ability to direct economic activity. China may yet be able to avoid the Japan trap, but only if its rulers learn to lighten up.”

The IMF’s reports on China have adopted an increasingly anxious tone, warning a year ago that every other country with credit growth on this scale and at this pace has landed in a broad financial crisis.

Most of the stimulus is being deployed through a pipeline that starts with an expansionist central bank money supply policy, then flows through the “pillar” state-owned banks to somewhat shadowy provincial government investment vehicles, that distribute the money to state-owned firms, especially in construction.

But there is a darker take on this money trail. Beijing, Xie says, is running “a gigantic monetary bubble that has corrupted virtually every corner of the economy”.

There remains a massive gap between the credit that has gone to companies, huge though that amount is, and the total. A large proportion cannot be accounted for.

This, it is now increasingly believed, is being stolen. Zhou Yongkang, the godfather of China’s oil and gas industry who is now jailed for life, owned up to taking $20bn and distributing it among 300 relatives and friends.

It now appears likely that many more such figures must be stealing, through fake invoices and fake projects, similar amounts — because the total is too big to be ­accounted for by “zombie companies”.

This helps explain why the anti-corruption Central Commission for Discipline Inspection has become, under Xi, the most powerful agency in the party-state. But despite this dire collateral cost, the stimulus tap can’t be turned off because without it growth will slide.

Ultimately, the unwinding is likely to start at the other end — as banks run out of sources of funding despite the streams still flowing from the central bank. A key provider decides to pull back, other players freeze, and a recession can strike before defences can be assembled.

Of course, a recession would not mean the end of the world’s second-biggest economy — though there might be political ramifications hard to predict. Those who believe China could never suffer such a blow, will find it harder to respond than realists who expect governance mistakes but also respect the country’s cap­acity to recover, and to learn.

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Rowan Callick, China Correspondent Beijing