After sparking a wave of risk aversion across markets earlier this year, the Chinese economy — the second largest in the world behind the United States — has made a stellar and somewhat surprising recovery in recent months.
The industrial sector is stabilising, helped in part by a renewed push from policymakers to buttress economic activity by bringing forward new infrastructure and residential property investment.
It’s been a remarkable turnaround, not only in the economic data, but also in sentiment expressed by investors.
The only problem is that it’s been built on a surge in credit growth, or debt.
This chart from the ANZ shows how China’s credit-to-GDP ratio gap currently sits compared to the peak seen in other nations before the onset of past financial crises.
For some background, the gap — calculated by the Bank if International Settlements (BIS) — is designed to identify the build-up of excessive credit and is calculated as the difference between the ratio of private non-financial credit to GDP against its long-run trend.
According to Kieran Davies, an economist at ANZ, “the gap provides an early warning signal for financial crises”.
Though below the levels seen in other nation’s prior to financial crises in recent years, the gap is not only elevated but continuing to grow, an unnerving development given the importance of China to the outlook for the global economy.
“China’s gap recently reached an extreme of 30%, which is the highest level in the 21-year history of the series and the highest current reading of any of the countries monitored by the BIS,” notes Davies.
“We view this as a downside risk to Australia’s outlook given China is our largest export market.”
It’s a risk that has not been lost on Australian policymakers, both past and present.
Here’s a snippet from a speech delivered by current RBA governor, Philip Lowe, last month in which he expressed his concerns:
Another area [to watch very closely] … is the unfolding transition in [China, which] … is also dealing with the consequences of a large build-up of debt in the private and state-owned business sectors. … [To date] there has not been a major interruption to growth … partly because the economy is still being supported through fiscal policy, including expenditure on infrastructure. The Chinese authorities face a difficult trade-off. Measures to address industrial overcapacity and the very high levels of debt in parts of the economy are necessary over the longer term but they are not helpful for growth in the short run. It remains a work in progress, and we all have a strong interest in their managing this trade-off as smoothly as they can.
The warning from Lowe echoed similar remarks from former RBA governor, Glenn Stevens, in August in which he pondered the question “whether those excesses can be gently landed without a crash?”
“The Chinese authorities are very conscious of that. It’s not as though they don’t realise the various risks that are there. They do. But it’s quite a tall order to kind of bring all this back down to earth gently,” Stevens said in August.
While no one argues that Chinese policymakers faced a mammoth task to reform its economy in the wake of the unprecedented stimulus splurge initiated in the wake of the global financial crisis, something that led to many of the imbalances within the economy seen today, the latest round of stimulus appears eerily familiar to that implemented in past years: build things financed by debt.
In a research note released last month, Gerard Burg, senior Asia economist at the NAB, said that this underlines the conundrum facing Chinese policymakers: either they let growth slow by pulling back on credit growth or keep accumulating debt in order to bolster short-term growth, creating medium-term risks surrounding financial stability.
Though Burg does not anticipate a Chinese financial crisis in the short term, he suggested that “continuing to allow credit growth – particularly to highly indebted state-owned enterprises (SOEs) – adds to medium-term risks for China.”
Though the latest round of investment has helped to boost economic activity in the short term, it’s little wonder why so many, including Davies and Burg, are concerned that it’s merely adding to the risks of a hard economic landing arriving in the years ahead.