China’s mounting debt: falling-off a cliff or fueling future growth?
For years, many China watchers, including myself, have been saying China needs a significant economic correction. However, China has deftly dodged a need for restructuring through an ability to dictate economic policies and favorable external economic conditions. So, with nearly daily news of the Middle Kingdom’s economic slowdown, mounting bad debt, and overheated markets, is now any different than in the past?
While Chinese capitalism has worked wonders for more than two decades, China is no longer able to chart its own economic path. As the world’s second largest market, it is inexorably tied to global market conditions and fluctuations. For the first time in over a decade, China’s GDP is forecast to grow at only 7% in 2015, and many pundits believe it will likely be less. China, which is quite well known for maintaining its magical growth numbers through high levels of public spending, could very well announce a year-end 2015 GDP growth rate of 6.9%. While this will not be far off from the forecast of 7%, it ushers in a new normal of performing under its annual growth targets. These are coordinated moves to demonstrate that slowing growth is good for China without dealing with the ramifications that real growth may be far below this publically stated level.
China’s entire economic model has created an enviable Mount Everest of economic growth and prosperity. The question now is, has the economic miracle that is China been formed as a rock solid mountain, or as a huge cliff that could easily create a disastrous land slide? The housing and stock market booms, which seemed to have no end are looking more similar to the 2008 global economic bubbles, than robust waves of growth. While China is still an export giant, its exports are certainly slowing. The HSBC PMI index, a well-respected index used to show the health of exports in emerging markets, clearly shows month-on-month that China is struggling with maintaining sustainable export growth. Chinese consumerism was supposed to quickly replace the global export engine and stimulate a new model of continued organic growth for the nation. While this has had some success, the historically conservative Chinese are slowing their spending habits as they question the health of their economy. In addition, China is facing more competition for FDI than ever before, as the ASEAN nations and India have become viable alternatives. One of the most important factors in the Chinese economic miracle has been the government’s astute policy creation and public spending, in both hard and soft infrastructure. Provincial and municipal governments alike, have spent billions of dollars creating industrial, commercial, and residential developments to further the prosperity of its inhabitants and ensure that each and every Chinese city is on a path to rapid modernization. Unfortunately, accumulated spending has been built on a mountain of debt. This poses a risk to the very viability of the Chinese banking system, which has been mandated to lend to government sponsored projects, whether real or imagined. According to the Wall Street Journal, local government debt was estimated at US$2.89 trillion in mid-2013.
Over the past 12-months, the central government has tried to make it harder for these local governments to borrow from the banks, forcing these provinces to use other methods to raise money. One of the key alternative methods the central government was championing to help handle this massive debt was to have local governments issue bonds to restructure old debt. In April, Jiangsu province was supposed to be the first province to issue bonds and was planning on selling US10.5 billion worth of bonds. Yet, this tactic has fallen short of its intended goal. What was supposed to start a chain reaction across provinces and municipalities, as a method to pay for the continued spending of large scale projects, while easing pressure on the central government, quickly failed. Jiangsu province delayed the bond sale after discovering limited interest from investors. Other provinces that were monitoring Jiangsu’s bond sale outcome, such as Anhui province, soon decided to delay their own bond sales as well. Investors’ tepid response to China’s provincial bonds was simply a result of savvy investors who understand the risk of future defaults on these bonds.
Perhaps the best indicator of China’s current lack of a viable solution to handle this mountain of debt, is the public announcement of a reversal of lending policy. This was best captured in the headline of the recent Financial Times article titled, “China orders banks to keep lending to insolvent state projects”.
As a long-term China observer and active participant in the economic miracle of the Middle Kingdom over the past 20 years, I have often been concerned that China’s economy has been on the edge of a cliff. But each and every time I state these opinions I have been proved wrong, by both market and policy changes. So this time I am a bit more cautious when prognosticating Chinese economic doom and gloom. I will not be surprised, if once again China figures out a way to defy gravity and continue to elevate the peaks of its economic mountain. Therefore, I will leave the analysis and forecasts to economists more highly trained than me.
What I do want to point out, is that now may be the perfect time for China to allow for, or perhaps even engineer a major economic correction. By doing so, they can avoid falling off a fiscal cliff, and instead stage a steady but more peaceful descent into an economic valley, that once traversed, will allow them to start developing a more sustainable model for long-term economic growth.