Chinese policymakers are aware that economic growth fueled by credit is unsustainable. To remedy that, they are making efforts to deflate the credit bubble.
This is expected to cause the world’s second largest economy to slow modestly in what’s been dubbed the soft-landing scenario. In 2013, China grew 7.7%.
But “government efforts to engineer a deleveraging could lead to a hard landing in China, if the policy response is misjudged,” writes Societe Generale’s Wei Yao.
In this scenario, year-over-year growth could collapse to just 2% and global growth could be cut by up to 1.5% in the year after the hard landing.
Last year, it was believed that inadequate government investment from Beijing or a sharp property market correction prompted by tight policies could trigger a crisis.
Now, Yao expects the crisis could be triggered by tighter liquidity conditions, the crackdown on shadow banking, and more restrictions on local government borrowing.
Here’s how the crisis will unfold according to Yao:
Two other events could however trigger a hard landing in China. First, the experience of 2008 showed that China is vulnerable to trade shocks. Exports contracted sharply on the back of the Lehman crisis, resulting in the loss of nearly 50 million migrant worker jobs in the two quarters after it took place.
Second, and more likely, a hard landing could be triggered if well-intended deleveraging gets out of control. Officials clearly want to reduce leverage; the first sign of this was a severe liquidity squeeze in June 2013, partly engineered by policymakers. Rates have dropped since last summer, but liquidity remains tighter than in H1 2013, and credit growth has steadily decelerated, particularly in the shadow banking system.
We expect further policy changes to reduce leverage. In particular, we think the banking regulator will tighten regulations further on shadow bank activities, including wealth management products (WMPs) and interbank transactions done by smaller banks to hide corporate loans.
Chinese debt markets have been underpinned by the belief that the central government has the resources, the control and the willingness to stand behind all the debt extended by both the formal and the shadow banking system. Although there have been concerns about corporate bonds, trust products and bank WMPs, there have been no defaults, and investors have always been made whole. To prove that it is serious about deleveraging, however, the central government will have to allow for defaults. Even in our central scenario, we expect some financial products to default for the first time in 2014.
Here it is in diagram form.
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