Part 2: Transformation or bust

August 13, 2014 11:32
China’s rapid credit expansion in the past five years puts it in the top five credit booms of the modern era. Photo: Bloomberg

In my last column, my young colleague Worth Wray and I continued our series exploring the risks posed by China’s rapid private sector debt growth and its consumption-repressing, investment-heavy growth model that is quickly running out of steam.

China’s overcapacity and over-indebtedness is not just the unfortunate consequence of hurried post-crisis stimulus but an inherent, and one can even say necessary, by-product of the command and control approach that has underpinned China’s development since the days of Deng Xiaoping.

And now even the IMF is concerned about the escalating risks of a hard landing sometime between now and 2020 unless Beijing moves forward with its urgent reform agenda.

An IMF staff report published last week said China’s reliance on credit expansion and fixed-asset investment is becoming increasingly dangerous.

Total social financing (the broadest official measure of domestic lending) has grown by 73 percent of GDP over the past five years, putting China’s ongoing credit boom among the top five most explosive instances of lending growth anywhere in the world since World War II.

There are no cases in modern history where an economy has managed to avoid an outright bust after experiencing rapid lending growth anywhere in the neighborhood of China’s ongoing credit boom. None.

The report highlights five sectors -- real estate, corporations, local governments, banks, and in particular, shadow banking. In almost every sector, the specter of significant to massive overleveraging is noted.

The worrying sign is, after a period of decelerating economic activity in the first quarter and just one historic corporate default in early March, the State Council announced in April what could be best described as a mini stimulus.

The State Council seems to be reconsidering – or at least delaying – its reform agenda.

In the months since the State Council’s announcement and Premier Li Keqiang’s subsequent guarantee that 2014 economic growth would top 7.5 percent, efforts to boost aggregate demand and encourage “targeted” credit growth have led to a turnaround in lending activity, a surge in infrastructure fixed-asset investment, slightly better real GDP growth.

But a closer look at purchasing managers’ indices shows that the stimulus-fueled bounce in economic activity has lifted overleveraged, investment-heavy, low-margin “old-economy” sectors such as heavy industry at the expense of more promising, high-margin “new-economy” sectors like services.

So, here’s the one trillion yuan question. How should we interpret the recent bounce in Chinese economic activity when maintaining a 7.5 percent annual GDP growth target through the application of stimulus and more debt seems to directly contradict Beijing’s aggressive reform agenda?

In the process of writing this letter, I spoke with a handful of brilliant economists including Steve Wang, David Goldman and Uwe Parpart at the Hong Kong-based Reorient Group, who come to very different conclusions about the ongoing transformation in China and the eventual outcome of its ongoing debt drama.

Yes, they argue, the old Chinese smokestack economy (dependent on low-value-added manufacturing exports and fixed-asset investments in infrastructure, mining, and real estate) is fading away and may drag somewhat on the banking sector; but non-performing loans, even if the actual numbers are several times larger than officially reported figures, are still manageable; and accordingly, the banks may be undervalued instead of posing a systemic risk.

Looking forward, the Reorient economist team argues that a new China is rising, with an increasingly empowered consumer class and explosive growth in high-margin sectors such as services and technology.

China has everything it needs to make the next great leap forward, they said, and history has taught us that the State Council tends to allocate resources and drive revenue in the right sectors over time.

There may be some volatility in the reform process (as we are seeing this summer); but the optimists at Reorient believe China is already rebalancing in the right direction, with a greater share of GDP driven by consumption and a falling trend in fixed-asset and real estate investment.

Or at least that was true until the mini stimulus in April. Now we are seeing a big bounce in investment and continued softening in the real estate market – a sign that not only is Beijing moving away from rebalancing but also that it is not in full control.

Reorient would argue that this is just a pause in the rebalancing process to shore up growth and prevent manageable vulnerabilities from becoming unmanageable problems, but John and I are starting to think it represents a more important about-face in policy.

It is becoming painfully clear to us that Beijing’s reformers are losing their resolve, not because they do not have the stomach for reform but because they know aggressive reform that requires a slowdown in growth and harder corrections within “Old China” sectors can burst the debt bubble and/or leave China more vulnerable to shocks from abroad.

As John and I highlighted a little earlier, China’s rapid credit expansion over the last five years puts it in the top five credit booms of the modern era; and so it will be very difficult to make the transition without a great deal of pain.

For example, in terms of market discipline, truly rebalancing away from overleveraged, low-margin “Old China” sectors toward still-repressed, high-margin “New China” sectors also requires that China’s central planners step back to allow widespread defaults in bloated industries so that capital can be freed up for more productive uses.

These kinds of credit events can be extremely destabilizing, as the International Monetary Fund repeatedly mentioned in last week’s report.

John and I have to think there is a reason Beijing allowed one default earlier this year and then quickly changed its policy. The reformers’ test likely revealed more weakness than expected.

And while conventional wisdom suggests that China’s bank leverage ratios are more than manageable, whether they actually will be ultimately depends on whether China’s banks are reclassifying and rolling all but the worst loans.

We have seen this movie before in Japan and know that manageable rot within a still largely state-controlled banking system can explode into higher-than-expected NPLs in the event of a real crisis.

The market has no idea how exposed China’s banks are to the inevitable slowdown, and any kind of sudden realization of the facts will inevitably lead to a system-wide loss of confidence.

That’s why we believe Beijing may be rethinking its reform agenda and delaying all but the most harmless shows of reform progress. The reforms required to set China onto a sustainable growth path may also pop its debt bubble; and if so, no one knows better than Xi Jinping.

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A noted financial expert, a New York Times best-selling author, an online commentator, and the publisher of investment newsletter Thoughts from the Frontline