China’s rise to economic prominence over the past two decades has benefited many countries, including Australia.
As a commodity-rich nation on China’s doorstep, Australia benefited more than most thanks to its insatiable appetite for its natural resources, helping its transition towards a predominantly urban, highly-connected economy.
However, as many are acutely aware, that economic transformation has occurred at a rapid pace, particularly in the period either side of the global financial crisis, with policymakers rolling out vast stimulus programs to help build the China of tomorrow.
While that’s ensured Chinese economic growth has maintained levels deemed appropriate by policymakers, boosting the Australian economy with it, the build-at-all-costs mindset has also delivered an increasing level of risk, particularly when it comes to debt levels.
As Australia’s most important trading partner, it’s something the Reserve Bank of Australia (RBA) has been keeping a close eye upon.
To borrow a well-used analogy, the RBA is acutely aware that if the Chinese economy sneezes, Australia’s will catch a cold.
That point was reinforced by the release of the RBA’s semi-annual financial stability report last Friday, which warned that financial stability risks in China “remain high” despite recent attempts from policymakers to address them.
“Debt levels have increased significantly over the past decade, largely driven by corporate borrowing,” the RBA said.
“Relative to GDP, China’s corporate debt exceeds that of most advanced economies, and is more than three times higher than in economies with comparable per capita incomes.”
This chart from the RBA shows the level of non-financial corporate debt in China as a percentage of GDP, measuring how it ranks to the level of real GDP per capita of other advanced and developing nations.
China does stick out from the rest, with non-financial corporate debt as a percentage of GDP significantly higher than other nations with comparable levels of real GDP per capita.
And, underscoring the RBA’s concerns, it notes that much of the growth in corporate debt since the GFC was funded through less-regulated channels.
“A significant part of the run-up in corporate debt has been funded through less regulated and less transparent ‘shadow banking’ channels,” the RBA says.
“Many financial institutions have funded the increase in lending with short-term borrowing and wholesale finance from other domestic financial institutions.”
Given the rapid growth in debt sourced from non-traditional sources in recent years, the RBA says that this combination increases the risk of a financial shock at some point in the future.
“Together, these developments make the system more vulnerable to adverse shocks, by raising considerable credit, liquidity and contagion risks,” it says.
“This suggests a heightened risk that loan losses and funding pressures in the shadow sector could quickly cascade through the financial system.”
Cascade. Not exactly the word you want to hear when it comes to China’s financial sector.
As the RBA explains, despite the small financial linkages between China and the rest of the world, any potential crisis would still be felt, especially in nations with strong trade ties, ie. Australia.
“If financial risks were to materialise in China, the negative effect on China’s economy could be substantial,” it says.
“Direct financial linkages between China and other economies are generally still small, limiting the spillovers through this channel.
“Rather, a disruption would most directly affect countries with strong trade links to China, including Australia, with second-round effects on a broad range of countries through weaker global growth. Weaker confidence and higher volatility in financial markets would also have global effects.”
Given China’s dominance of global trade flows, as the RBA suggests, the impact on the global economy could be substantial.
With corporate and household leverage in the Chinese economy only continuing to increase, it raises the important question as to how policymakers will be able to deal with these risks without causing a pronounced slowdown in economic activity.
That, says the RBA, will be a tricky balancing act for Chinese regulators to navigate in the years ahead.
“The authorities’ commitment to moderate riskier financing could be tested if economic growth targets are threatened,” it says.
“Given the already high level of risk that has built up in the financial system, the authorities are likely to face a trade-off between strong regulatory action that could trigger financial and economic disruption and a more cautious approach that may allow a further build-up of risks.”
It’s not a particularly palatable scenario, no matter which way policymakers choose to go.
Should they look to curb rapid growth in debt levels through tighter regulation and reform, it could lead to a steep deceleration in economic activity, something markets witnessed first hand in early 2016 when concerns flared about the health of China’s economy, in particular the financial sector.
Then, as so often has been the case in the post GFC-era, policymakers responded to the growth slowdown by ramping up infrastructure and residential investment, much of it funded by debt.
And while that avoided the risk of an even sharper near-term growth slowdown, it arguably added to the longer-term financial stability risks associated with continued debt accumulation.
In the RBA’s opinion, the longer near-term growth goals are prioritised over longer-term financial stability risks, the greater the likelihood that a disruptive financial crisis could eventuate.
“The more that leverage and risky lending grow, the more likely that China’s economic transition will include a significant financial disruption of some form,” it says.
And it’s not just the RBA concerned about China’s current credit-fuelled growth trajectory.
Earlier this year, the International Monetary Fund (IMF) also warned that China’s current credit growth was “dangerous”, increasing the risk of a sharp economic growth slowdown — or worse — in the years ahead.
“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 said in August.
“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 debt compared to the past.
And that increased reliance on debt to deliver short-term economic growth goals has seen China’s non-financial credit-to-GDP ratio increase by 60 percentage points to around 230% over the past five years.
As the IMF explains, credit growth 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,” the fund said.
“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.”
Similar research from the Bank of International Settlements (BIS) also suggests the risks of a financial crisis have grown since the GFC as a result of the sharp increase in China’s debt levels.
On any number of metrics, China will be creating history if it manages to successfully mitigate the risks alluded to by the IMF and BIS, and more recently the RBA.
It clearly won’t be easy if the example of early 2016 is anything to go by, but few disagree something will need to change in order to guarantee the longer-term prosperity of the Chinese people.
That all but ensures that there’ll be plenty of interest on China’s 19th Communist Party Congress when it begins later this week, and includes the government’s plans and objectives for the economy looking five years ahead.
It will help shape the outlook for the global economy in the years ahead, especially nations whose economic fortunes are closely aligned to those of the Chinese economy.
At the top of that list is Australia.