Unfortunately, China now faces significant problems.
The weakness of its two major trading partners (the U.S. and Europe) means export demand is likely to remain subdued. Domestically, the side-effects of debt-driven investment are now emerging.
China’s ability to sustain high growth levels is questionable. Specifically, its capacity for further stimulus is uncertain. The ability to adjust the economy to the new economic environment poses unprecedented challenges in rebalancing consumption and investment within China. Slowing growth also poses social and political challenges. Chinese Premier Wen Jiabao has repeatedly admitted that the “stabilization and recovery of the Chinese economy are not yet steady, solid and balanced”.
The conventional view is that China will be able to continue to stimulate demand using its large foreign exchange reserves, large domestic savings and low levels of debt.
China’s $3.2 trillion in foreign exchange reserves are invested in predominately in U.S. dollars, euro and yen, primarily in the form of government bonds and other high-quality securities. These assets have lost value, through increasing default risk (as the issuer’s ratings are downgraded) and falls in the value of the foreign currency against the renminbi.
Risks and realities
Attempts by the Chinese to liquidate reserve assets would result in sharp falls in the value of the securities and a rise in the renminbi against the relevant currencies with large losses. The reserves also force China to buy more dollars, euro and yen securities to defend the value of the existing portfolio, increasing both the size of the problem and risks.
In reality, China ultimately will have to write-off these reserves, recognizing its losses. It can do so of its own volition or have the value of its investment reduced over time through falls in the value of the currency in which the security is denominated.
This equates to a real loss of wealth as China has issued renminbi or government bonds against the value of these investments.
China also has far greater levels of debt than commonly acknowledged, although the bulk is held domestically. The Central government has a low level of debt — around $1 trillion (17% of GDP). In addition, state-owned and state-supported entities have debt totalling $2.6 trillion (42%); local governments about $1.2 trillion (19%); policy banks $800 billion (13%); Ministry of Railways $280 billion (5%), and government-backed asset-management companies set up to hold non-performing bank loans $300 billion (5%). The total debt, around $3.6 trillion, is 59% of GDP.
The debt levels are exacerbated by what Michael Pettis in his book “The Volatility Machine” describes as an inverted debt structure — where borrowing levels increase when the economy has problems. When the economy slows, China’s debt levels, both direct and contingent, will increase rapidly.
China also has limited flexibility in managing its currency. The renminbi has risen 30% since Beijing adopted a policy of managed appreciation and revalued its dollar peg in July 2005.
As growth and exports slow (the trade surplus and foreign exchange reserves are falling), China needs to let the renminbi fall to cushion the adjustment. But developed countries are all seeking to increase their share of limited global growth by lowering the value of the currency. In a U.S. election year, the risk of trade protectionism and the prospect of being referred to the World Trade Organization for currency manipulation limit China’s policy flexibility.
Unhappy landings
The reality is that since 2007/ 2008, a part of China’s growth has been an illusion. Since 2008, China’s headline growth of 8%-10% has been driven by new lending averaging around 30%-40% of GDP. Up to 20%-25% of these loans may prove to be non-performing, amounting to losses of 6%-10% of GDP. If these losses are deducted, Chinese growth is much lower.
The China economic debate is focused on the alternatives of a soft or hard landing. Even China has stated that growth will slow.
The case for a soft landing assumes that the investment and property bubbles are less serious than thought. Beijing has sufficient financial capacity to boost growth by loosening monetary policy and bank lending, while adjusting specific policies, such as lifting restrictions on housing sales to prop up prices.
In that case, China is able to boost domestic consumption, replacing investment as the key driver of its economy. Excess capacity is gradually absorbed as the world economy recovers. Growth comes down gradually, without causing social and political disruptions.
In contrast, the case for a hard landing assumes the rapid and destructive unwinding of asset-price bubbles and problems within the Chinese banking system. A poor external environment and losses on foreign investment exacerbates the problem. Growth collapses, triggering massive social unrest and political tensions.
The end of a cycle of debt- and investment-driven growth is typically disruptive. Japan’s experience, which China has drawn on in shaping its economic model, is salutary. Japan grew on average by 10% in the 1960s, 5% in the 1970s, 4% in the 1980s, and has remained stagnant since, as it adjusts to the deflation of its debt-fueled bubble.
As an old Chinese proverb, probably apocryphal, holds: “There is no feast that does not come to an end.”
