Ever since China’s new leadership took the helm in November 2012, they have been pushing through economic reforms rather aggressively.
These reforms have not been without pain. They have, in part, contributed to slower economic growth, and to a rise in defaults.
So, why have policymakers traded high growth for slower growth? What would happen if China abstained from any reforms? What if Beijing didn’t try and curb lending, or shadow banking?
More liquidity and would probably lead to continued inefficient allocation of resources. It’s likely that the property market would swell, China’s excess capacity would worsen, and money would generally go into projects that were basically intended to drive GDP.
Banks can continue to roll over debt and continue to finance new projects with increasing amounts of credit. While this would stave off any pain at the moment, it would just push the problems further down the road and risk exacerbating them.
In recent years we’ve noticed that credit growth has far outpaced economic growth, prompting Societe Generale’s Wei Yao to ask where all the money has gone. According to Yao, China is facing its own Minsky moment where periods of speculation and credit growth inflate assets can only to lead to a crisis.
Runaway credit train
In a Bloomberg View column, Patrick Chovanec, chief strategist at Silvercrest Asset Management, wrote that “China’s leaders are riding a runaway train that they don’t quite know how to stop. And they’re running out of track.”
And when this does go sour, its impact will be felt beyond China.
“China’s credit-fuelled investment boom has been a driver of metals prices and machinery exports,” wrote Chovanec. “China has become the world’s largest automobile market, its largest oil importer, and its largest buyer of gold. Although foreign banks have relatively little direct exposure to Chinese financial markets, capital flows into and out of the mainland are potentially large enough to have a significant impact on asset classes not normally associated with China. A financial train wreck would send tremors through global markets.”
The end result
“Japan’s debt didn’t start to rise at a similar speed until the mid-1980s,” wrote Lombard Street Research’s Diana Choyleva. “China’s debt has surged sooner because its economy is much bigger than Japan’s was.”
She added that debt has grown much faster in the last five years than it did in Japan during the same stage of development. And the rate of debt increase is “as important, if not more important, in precipitating a crisis than the absolute level of debt.”
“The world is just not big enough to let China continue to increase its income per capita and waste its savings on a vast scale for years to come,” she said. “The financial crisis was the beginning of the end of China’s export and investment-led growth model.”
Choyleva warns that China’s burgeoning debt has made it, so that its ‘Bear Stearns moment’ may strike at any time.
This would basically change the market’s perception of inherent credit risk in the Chinese economy and cause a liquidity crunch. If China were to “mop up the mess while still wasting capital, it could be only 2-3 years before a major financial crisis hits the economy.”
Alaistair Chan at Moody’s told Business Insider that if China fails to push through reforms “the end result would be that the economy stagnates in a middle-income trap.”
“Zero reform would mean that productivity growth would continue coming entirely from adding more capital to labour, rather than from improved efficiency. This method of growth is already hitting diminishing returns and if it continues then China’s potential growth rate would fall sharply.”
If reforms aren’t pushed through, Standard Chartered’s Stephen Green thinks inequality and corruption will rise as growth slows and it would leave China vulnerable to foreign and domestic shocks. “At the same time, more money and talent would leave for sunnier and clearer skies. Its not a pleasant thought — and the sense of crisis, and the need to avoid such a future, is partly whats driving Beijing these days.”
Not everyone is as gloomy. Chan says “it should be noted that this won’t necessarily result in a financial crisis or hard landing because if productivity is slow then the government won’t need to pile on much debt/investment to boost employment.”
Yao meanwhile is far more blunt on the subject. In the absence of reforms, “China could potentially face its own lost decade.”