China has a debt problem, and if it continues to place short-term growth goals ahead of managing longer-term financial stability risks, it runs the risk of suffering a sharp growth slowdown, or worse.
That’s the latest assessment from the International Monetary Fund (IMF) who describes China’s current credit growth trajectory as “dangerous” given the precedent set by other nations where boom-bust credit cycles have occurred in the past.
“International experience suggests that China’s credit growth is on a dangerous trajectory, with increasing risks of a disruptive adjustment or a marked growth slowdown,” the IMF says.
This chart from the group explains why it’s concerned.
A whole lot of debt has been required in order to achieve the Chinese governments annual GDP growth targets, set this year at a minimum level of 6.5%.
“In 2007-08, new credit of about RMB 6.5 trillion was needed to raise nominal GDP by about RMB 5 trillion per year. In 2015-16, it took RMB 20 trillion in new credit.”
Put another way, in order to deliver the same amount of economic growth, it’s required a significantly faster increase in credit.
According to the IMF, this suggests that “credit efficiency has been deteriorating, pointing to increasing resource misallocation.”
“Credit to certain sectors (industrial), firms (SOEs), and regions (Northeast) is significantly higher than their value added, suggesting that they use credit relatively inefficiently,” says the IMF.
The common theme the IMF has highlighted is that they’re all symbolic of the old China economic model that relied upon debt, heavy industry and state-support to deliver the government’s growth targets.
And while China is attempting to curb these inefficiencies, and turn its economic model towards a path where services and consumption powers economic output, when the economy hit turbulence at the start of last year it immediately turned to credit, property and infrastructure investment in order to boost growth.
Everything old was suddenly new again, and the economy hasn’t looked back since, even accelerating in the last quarter as the government looked to spruce up growth ahead of a leadership changeover at the end of this year.
However, the IMF thinks that by attempting to prolong the economic boom, the Chinese government risks creating an even larger bust.
It points out that credit extended to China’s non-financial sectors has more than doubled in the last five years, seeing the nation’s non-financial credit-to-GDP ratio increase by 60 percentage points to about 230% last year.
That rapid debt accumulation has seen China’s credit-to-GDP gap — the percentage that the ratio exceeds its long term trend — rise to around 25% more than usual, leaving it well above the 10% level the Bank of International Settlements (BIS) deems to be an early warning signal that debt accumulation levels may be unsustainable.
As the IMF explains, the growth in the credit gap of such magnitude has not delivered particularly palatable economic outcomes in the past.
“We identify 43 cases of credit booms in which the credit-to-GDP ratio increased by more than 30 percentage points over a 5-year period,” it says.
“Among these, only 5 cases ended without a major growth slowdown or a financial crisis immediately afterwards. However, considering country-specific factors, these 5 country provide little comfort.
“In addition, all credit booms that began when the ratios were above 100% — as in China’s case — ended badly.”
Not exactly an ideal situation should it prevail given China is the world’s second-largest economy.
A growth slowdown, let alone a slump, would have significant negative implications for the global economy.
In the short-term, the IMF says that several factors such as high household savings, a current account surplus, its small external debt and various policy buffers will help mitigate the near-term risks of a financial-led growth slowdown.
However, it warns that should China continue down its current path, the risks of a financial crisis will only continue to increase.
The IMF delivered a blunt assessment on what needs to occur to mitigate these risks.
“Decisive policy action is thus needed to deflate the credit boom smoothly,” it says. “A precondition is to deemphasise high and hard GDP targets and the attendant excessive credit necessary to achieve these targets.”
In order to support the economy as credit growth slows, it says that a “comprehensive strategy is needed to increase credit efficiency by reducing demand for least efficient uses”, adding that “financial reforms are also necessary to bolster the regulatory and supervisory framework, including closing loopholes for regulatory arbitrage, reining in leverage and increasing transparency of nonbank financial institutions and wealth management products.’
A complex task, and one that is not without its risks.
In a nutshell, the IMF is recommending that China should ditch its annual growth targets requiring oodles of debt to instead focus on fostering self-sustaining forms of growth.
It will be interesting to see whether the upcoming leadership reshuffle will see the government oblige.