by Roy C. Smith
from eFinancial News, May 25, 2105
Many China observers have pointed out that rapid growth without basic reforms brings the risk of a major financial crisis. China said it would undertake the reforms, but last week, fearful of strikes and other protests amidst declining growth, it abandoned them. Fasten your seat belts.
After the financial crisis of 2008, China did what other countries did – it provided fiscal and monetary stimulus to restore growth, at the cost of significant increases in debt and the risk of nonrepayment. Unimpeded by a democratic political process, China’s fiscal and monetary stimulus efforts were the largest ever undertaken by any country.
It worked,but only for a while. China’s GDP growth rate, which had been 13% in 2007 but more than halved to 6% in 2009, rebounded to 12% in 2010, but its total debt increased by $21 trillion, from 158% of GDP in 2007 to 282% in mid 2014, according to a McKinsey study. Loans issued by financial institutions and non-financial corporations grew from 96% of GDP to 190%. Nearly half of this debt was related to real estate, but much of the rest is in stimulus projects undertaken by various provincial, city and other local governments.
During this time, the central bank was seeking to reform the financial system, by clarifying the limits of deposit insurance, adopting market rate lending and deposit taking practices and by reining in lending for real estate and stock purchases, and for speculative projects by local governments.
To get around these rules, the loans were made instead to off-balance sheet subsidiaries of local authorities known as “local government financing vehicles”. By the end of 2014, $560 billion of such debt was outstanding.
But China’s growth rate has declined sharply since 2010, putting serious pressure on the ability of local governments to repay debt amounting in total to about $3.5 trillion. Debts to money-losing state owned enterprises (SOEs) and other corporations (about $6 trillion altogether) are also a problem.
China has been awash in money for the past few years in an effort to reverse the declining growth conditions. Instead, the excess liquidity has pushed up real estate prices in major cities by 50% since 2008 and the Shanghai Stock Index by 120% since November.
Even so, large parts of China are still suffering from deteriorating economic conditions.
In April, Premier Li Keqiang visited three “rustbelt” provinces in the northeast where he observed much weaker growth than expected and disgruntled workers. Strikes and other worker protests have been running about three times the rate of recent years.
Few existential threats to the ruling Communist Party are greater than massive worker protests.
So the Party did the most pragmatic thing it could to safeguard its interests – it abandoned reform to renew monetary stimulus.
In April, the Politburo announced a programme of “prudent monetary policy” to offset the effects of the cyclical downturn into which the economy has settled. This was followed by a joint directive issued by the finance ministry, the banking regulator and the central bank, explicitly banning financial institutions from delaying funding to any local government project started before the end of 2014, and requiring that any projects unable to pay existing loans should have their debts renegotiated and extended.
SOEs in similar difficulties would no doubt receive the same benefit, though such too-big-to-fail treatment presumably could be managed quietly.
Accordingly local government and SOE debt will increase further, as will the portion of it that is distressed, hoping to push the problems far out into the future.
Thus, China seems to be sliding into an inevitable financial crisis similar to those experienced by Japan in the early 1990s and by Thailand, South Korea and Indonesia in the late 1990s.
These earlier Asian crises were similar in nature – they all contained stimulus efforts to encourage growth, asset bubbles, massive lending to SOEs or large, distressed industrial groups, and market crashes once the difficulties became publicly known. The crashes brought tough economic times, changes in government and long periods of growth rates well below pre-crisis levels.
In 1978, Deng Xiaoping announced a fundamental change in government policy to achieve economic growth by allowing a private sector to develop. At the time, the average Chinese had realised very little, if any, economic improvement since Mao’s Revolution in 1949, the Great Leap Forward of 1958-61 and the 1966-76 Cultural Revolution.
Deng’s policy has been a great success, but having now abandoned Communism, the people may wonder why they need a Communist Party running everything. The president, Xi Jinping, is well aware of the dichotomy, and is hoping to trade more prosperity, less corruption and an enhanced, more powerful national image for continued Party control.
But there is another side to the bargain. The opening of the economy to market forces that is part of Deng’s legacy had to be accompanied by reforms and disciplines necessary to make a market economy function effectively. Otherwise the massive Chinese economy, spurred on by recurring stimulus, misallocation of resources, corruption and devolution of decision making authority away from Beijing, could tear itself apart.
The government has apparently understood the need for such reforms, and recognised that the growth rate is likely to settle at around 7%. But implementing reforms in a decelerating economy has proved more difficult than Xi and his colleagues expected.
Recent indicators suggest that China’s growth rate in 2015 may fall below 7%, which could result in a nasty backlash from the 280 million indigenous migrant workers likely to be the first to face layoffs. Hence, all hands to the pumps to check any further decline in growth.
However, having suspended reforms to sustain growth puts China in danger of greatly expanding its already large supply of non-performing loans, and one day having to face the consequences of owning up to them.
All this suggests a financial reckoning to come, one that could be very rough.