The economy is continuing to slow down. Traditional ways of forcing it into higher gear are no longer working, and there is no indication that the authorities have a solution up their sleeve. They also have to consider mounting debt levels, although, contrary to frequently heard warnings, there is still little near-term risk of a full-fledged systemic crisis. Politically, President Xi Jinping is presiding over a crackdown on civil society unlike anything seen in this country since the repression that followed the Tiananmen massacre. Under him China will also keep showing considerably more aggressiveness internationally, in both the trade and military spheres.
There is one thing I learned long ago about Chinese economic reports: When the reality gets darker they become a lot scarcer. They also become totally unreliable as city and provincial administrators double their efforts to massage the numbers to Beijing’s liking. These days, the official control of the scripted data flow is even tighter than usual, to the point where journalists and companies are facing criminal charges if they release news that officials believe could hurt stocks or the currency. There is intense pressure on the media to focus on positive things reflecting well on the Party and on President Xi and to omit anything that is negative.
The crackdowns on people offering a different story than Beijing wants to hear are telltale signs that the country is bumping into problems. Even those official numbers that are available suggest, if looked at carefully, that all’s not well in the Land of the Middle. Granted, real gross domestic product gained by 6.7% annually in this year’s second quarter, matching the performance in the first. While in the official target range for 2016 of 6.5%-7.0%, though, this was under the 6.9% booked for all of 2015 and below the 7.3% registered for 2014. Moreover, the statistics indicate that private consumption slowed and private investment cratered, while exports declined by 3.9%, following a 10.2% drop in the first three months. In other words, it appears that growth depended heavily on government-sponsored investment and cheap credit. Exports might have done worse had it not been for a depreciation of the yuan that so far this year has brought the exchange rate down by 6% against a basket of currencies that include the dollar, the euro and the yen.
In the months ahead, the negative forces will strengthen, not fade away. Further impaired by the Brexit shakeup and rising geopolitical tensions, the international business climate and outlook do not hold much promise for a significant increase in Chinese exports. Also, big markets such as the US are becoming more protective of their turf as the notion spreads that the PRC is not treating its partners fairly and is not living up to its WTO obligations. The Obama Administration has launched 13 trade enforcement actions against Beijing with that organization. It has imposed dozens of punitive tariffs on Chinese products after complaints from American industry that these are being “dumped” on the US market. Among the contenders for the US presidency, Donald Trump keeps accusing the Chinese of “stealing” jobs and manipulating their currency, and Hillary Clinton is not far behind with her assertion that if she makes it to the White House she will play hardball and make China “toe the line,” as she told AFL-CIO members in April.
Europe is also becoming increasingly concerned about the weakness of the yuan, judging from the discussions at this month’s meeting of the Group of 20 finance chiefs. Capital outflows from China ranged between USD 700 billion and USD 1 trillion in 2015. They have slowed recently only because the authorities toughened controls for companies and individuals. This, along with the fact that the country’s giant state firms hold large amounts of debt denominated in dollars, will limit how much further China’s Central Bank can allow the yuan to fall. And Chinese labor costs are rising, so much so that more & more industrial work gets farmed out to places such as Thailand and Vietnam.
In past years, the standard official answer to signs that growth may be falling short of targets was to throw the cash box at the economy and massively step up spending from the public till. This year, again, the CB has sent a flood of money into the financial system to perk things up. Reports that the consumer price index in May was just 2.0% higher than a year earlier may encourage it to try more of the same medicine, even though speculative bubbles seem to have begun inflating in investments as vastly different as housing and pork futures.
There are quite a few analysts who think that the splurge of credit and investment will yet culminate in a financial crisis. The IMF recently warned that corporate debt, which hit a record 237% of GDP in the first quarter, “remains a serious – and growing – problem that must be addressed immediately and with a commitment to serious reforms.” The Fund’s Number Two, David Lipton, speaking in Shenzen, warned that this debt load, which is “very high by any measure,” is “a key fault-line in the Chinese economy.”
Even China’s People’s Daily newspaper in May ran a front page interview with an unidentified “authoritative figure” who warned that skyrocketing debt levels could trigger a “systemic” financial crisis, and I would be the last one to deny this risk. Banks that have been driving the huge credit expansion since 2008 rely increasingly on volatile short-term funding with the help of sales of high-yielding wealth-management products, rather than on stable deposits. What is even more troubling, they are using creative ways to disguise risky loans as “investments,” the so-called “shadow banking” which makes traditional risk measurements virtually useless. They are doing so, inter alia, by hiving off loans from their balance sheets through partnerships with non-bank financial institutions such as trust companies and securities brokerages. Such investments are not classified as loans and defaults are not reflected in the banks’ NPL ratio. As shadow lending has surged, the complicated transaction structures have eliminated all clarity about where the risks ultimately reside.
Longer-term, this does indeed open up serious risks and should give rise to concern. In the short run, though, the dangers do not appear particularly great for a number of reasons. By flooding the banking system with cash the CB can ensure that banks remain liquid, even if non-performing loans rise sharply. The authorities have also launched a series of initiatives to pare back the bad debt that rightly belongs onto the banks’ balance sheets, including securitization. A government-led program forces banks to write off bad debt in exchange for equity in ailing companies, and there seems to be a new willingness to let the so-called zombie-companies die.
For now, though, the main policy problem is that it is difficult for any economy to absorb productively a huge injection of capital in a short period, given the limited number of profitable projects that are shovel-ready at any point in time. After 15 years in which China built tens of thousands of roads, airports, bridges and buildings, the economic benefit of adding more offers rapidly diminishing returns. Local governments are still weighed down by massive debt loads from previous stimulus efforts. More of their borrowed money is now going to service these obligations. Many of the new projects wind up losing money, adding still more debt. And with returns spiraling downward, more loans are at risk of turning sour.
So, while there is, as of now, relatively little danger of a systemic crash, individual companies in China need to be watched more closely than ever. This is not only because the state-owned enterprises are being given more official leeway for failing, but also because what is being passed off as “information” in China needs to be taken with a larger grain of salt. China’s rating agencies have awarded investment grade status to 99.5% of all public debt outstanding. They maintain that all but a fraction of corporate debt is safe, never mind that corporate defaults this year have jumped to three times the levels seen in the whole of 2015. Stock market analysts have issued almost unanimous “buy” recommendations for all companies in the Shanghai Composite index (China’s premier gauge) and the state-run media have been instructed to “sow harmony” wherever they can.
Without solid financial information it is difficult not just for company heads but also for policy makers to address the misallocation of capital that brought China to the point where in this year’s first quarter it needed four units of credit to generate a single unit of GDP. Unaddressed, this state of affairs will weigh increasingly on the economy – reinforced by the reverberations of a crackdown on corruption launched by President Xi that has resulted in literally hundreds of thousands of convictions and has terrified much of China’s business and political elite. What this ultimately could lead to is the type of recession-stagnation that Japan struggled with in the 1990s and 2000s, when corporate debt had mounted so high that conventional monetary policy became ineffective because companies concentrated on paying down debt and refused to borrow and invest even at bargain-basement prices…
- Core Competencies
- International Credit & Risk Management Online Course
- International Certified Credit Executive (ICCE)
- Certified International Credit Professional (CICP)
- On Demand Webinars
- Credit Learning Center
- International Trade Administration
- Credit & Country Reports
- Join FCIB
- About FCIB