The financial shock which has recently hit the emerging markets stemmed in part from a period of severe stress in the Chinese money markets, which has now been brought under control. But the challenges facing China are chronic, not acute. And since the country is much more than “first among equals” in the Brics, a prolonged slowdown in its economy would keep all emerging market assets under pressure for a long while.
Although China is probably not facing anything as dramatic as a “Lehman” moment, it will need to spend several years tackling the combination of excess credit and over-investment that has followed the Rmb4tn ($652bn) stimulus package of 2008. Hailed at the time as a masterstroke, the package has caused a hangover that has now been implicitly acknowledged by the new administration under reformist Premier Li Keqiang.
China is in the midst of a classic credit bubble. The ratio of total credit to gross domestic product has risen from around 115 per cent in 2008 to an estimated 173 per cent, an acceleration in credit expansion that has spelt danger in many other economies. Much of this has come in the poorly regulated shadow banking sector, where the annual rate of credit expansion exceeds 50 per cent. The Chinese authorities are signalling, correctly, that this must slow sharply.
The credit explosion has massively increased the debt service ratio in the economy, an indicator that the Bank for International Settlements says “reliably signals the risk of a banking crisis” (see BIS Quarterly Review, September 2012). The danger point for the debt service ratio, in a cross-country analysis of developed and emerging economies, was found to be around 20-25 per cent, while increases in the ratio of five percentage points or more were problematic.
Official figures for China are hard to find, but analyst Wei Yao at Société Générale says the ratio stands at about 39 per cent of GDP. This is considerably above the danger level, and much of the recent increase in credit is widely believed to have been used to extend the maturity of previous debts, another classic warning sign.
Local government finance vehicles have found their earlier funding streams (from land sales) running dry, so they are reported to have resorted in large size to these alternative sources of funds.
In order to soft land, credit growth will need to be reduced to single-digits for many years, compared to the 23 per cent annual increases seen since 2008.
Apart from the financial consequences of the credit expansion, there are now also real concerns that much of the resulting capital spending has been directed towards areas with low economic returns.
Private investment growth needs to slow to about 4% in the next decade to achieve a rebalancing of demand
For many years, China has been accused of relying too much on investment as the prime driver of its growth, both in generating aggregate demand and in boosting supply capacity. But these worries have always been countered by pointing to China’s low levels of capital stock per head, relative to more developed economies, and to the extraordinary GDP growth which has been achieved so far.
This also may have changed in the wake of the 2008 stimulus package, which raised the share of investment in GDP from about 42 per cent in 2007 to 47 per cent in 2013. International Monetary Fund economists (in Working Papers 12/277 and 13/83) suggest excess investment has grown to around 10 per cent of GDP, concentrated geographically in the inland provinces, and industrially in the manufacturing and real estate sectors.
The arithmetic required for a soft landing is once again formidable. Private investment growth needs to slow to about 4 per cent per annum in the next decade, compared to 10 per cent in the last, to achieve a successful rebalancing of demand and avoid wasted resources.
Why, then, will all this not lead to an acute financial shock? Recent stress in the Chinese money markets invites comparisons with the US in 2008, but this resulted from a deliberate signal from the authorities that excess lending in the smaller and shadow banks must cease. The large banks seem well capitalised, and are largely within the public sector, not the market economy.
With the public sector debt/GDP ratio just below 50 per cent, there is some fiscal space left to recapitalise the banks if needed. In previous episodes, the authorities have avoided disruptive bankruptcies and systemic banking failures. Unlike the rest of Asia in 1997, China has excess domestic savings, $3.5tn in foreign exchange reserves and no mismatch between the long-term domestic assets and short-term foreign liabilities of its banks.
No crisis, but a prolonged and difficult workout, is the most likely outcome.
Gavyn Davies is chairman of Fulcrum Asset Management and writes a regular blog on macroeconomics at FT.com