Michael Schuman
Once again, the world’s investors are turning their worried gaze toward China. And for good reason. Economic growth in the third quarter sank to 6.5 percent, the slowest pace since the depths of the global financial crisis in 2009. Car purchases fell last year for the first time in more than two decades. Apple Inc.’s warning in early January that iPhone sales in China were sagging alerted the world to how a slowing Middle Kingdom would drag down global growth and corporate profits. But the locals figured that out a while ago. Even after a recent uptick, the stock market in Shanghai has still plunged by more than a quarter from its 2018 high. The outlook isn’t any rosier. Tariffs on Chinese exports to the U.S. imposed by President Donald Trump are starting to pinch the country’s factories. A steep and unexpected plunge in imports in December signaled just how sharply the economy is decelerating. That’s led Beijing to turn the volume down on its bravado and negotiate with Washington to defuse the conflict.
A trade pact, if it happens, may soothe investors, and perhaps even juice economic growth—at least temporarily. But it won’t bring an end to China’s woes. While tariffs are a nuisance, the real problems run deeper, embedded in China’s financial structure.
What goes widely unnoticed is that China is already in crisis. No, it’s not the sort of hold-on-for-dear-life collapse the U.S. had in 2008 or the surprising, ferocious meltdowns the Asian Tiger economies experienced in 1997. Nonetheless, it’s a crisis, complete with gutted banks, bankrupt companies, and state bailouts. Since the Chinese distinguish their model of state capitalism as “socialism with Chinese characteristics,” let’s call this a “financial crisis with Chinese attributes.”
This crisis is not merely about the current slowdown in growth. It’s been going on for a while, and by the looks of it, isn’t going away anytime soon. How it’s resolved—or isn’t—will have repercussions much bigger than a few quarters of poor growth performance. This crisis is about China’s economic future and whether or not it can manage the structural transformation necessary to propel the economy into the ranks of the world’s most advanced. And it also will determine if China will be a pillar of global growth—or a threat to the world’s financial stability.
On the surface, the whole idea that China is in a crisis may sound ridiculous. Growth has tapered off, but it remains relatively strong—assuming you believe the government’s figures. Banks and companies aren’t tumbling into insolvency on a massive scale. The yuan has even shown signs of strength in recent days. While anxiety over the state of the economy has mounted—thus the pullback by Chinese shoppers—the mood in China hasn’t degenerated into the gloom that usually accompanies financial upheavals.
Crisis? What crisis?
True, China may never suffer the panicked fiasco that emanated from Wall Street in 2008. This financial crisis with Chinese attributes isn’t taking the same course as most others. Rather than a sudden explosion that destroys banks and jobs, China’s version is protracted, moving so slowly that it can be hard to notice. Ultimately, though, the cost and pain will be similar to—perhaps even worse than—that of the traditional crises we’ve come to expect.
A few years ago, some China watchers (this writer included) predicted the economy could tumble into a 2008-like collapse. All the warning signs for catastrophe were flashing bright red: a housing bubble, excess capacity in industries from steel to solar panels, and most worrisome of all, a debt buildup of gargantuan proportions. Total debt relative to national output surged to 253 percent in mid-2018, from only 140 percent a decade earlier, according to the Bank for International Settlements. No emerging economy since the 1990s has had such an outsize debt expansion and escaped some sort of financial calamity. China would have to defy history to dodge a debt disaster.
We’ve been watching and waiting for China’s Lehman Brothers moment—then waiting some more. It never arrived. Some analysts have come to figure it never will—that, indeed, China is too big to fail. The Chinese government, the new argument goes, has so many levers of control—over banks, big corporations, and capital flows—that it can suppress the sort of crisis a more liberal economy can’t prevent. This superpower was on display in 2015 after a stock market bubble burst, fueled by shifty lending and bureaucratic ineptitude. Money flooded out of the country as the currency staggered. What would likely have laid other emerging markets low was just another day’s work for China’s powerful mandarins. The government organized a stock bailout and clamped down on capital outflows. Crisis averted.
That approach is representative of Beijing’s overall strategy toward its debt problem. The government—obsessed with social stability—isn’t allowing the debt bomb to detonate. But the financial crisis with Chinese attributes is inflicting the same damage on the economy anyway.
As in any debt crisis, the health of China’s banks is being dangerously eroded. Although nonperforming loans officially reached the highest level in a decade at the end of 2018, they remain at less than 2 percent of the total outstanding, according to the government. Hardly anyone believes that statistic. Charlene Chu, a senior partner at Autonomous Research and one of the foremost experts on China’s credit woes, estimates that 24 percent of total credit, worth some $8.5 trillion, has gone sour. That may sound outrageous, but in the 1997 meltdown, nonperforming loans in Indonesia, South Korea, and Thailand reached about a third of their total loans.
As is often the case in crises, the true extent of the debt and the damage is probably higher than anyone can guess. In an October study, S&P Global Ratings noted that the amount of local government debt in China remains a mystery, since so much of it is held off balance sheets. That “hidden” debt could be “multiples of the publicly disclosed amount”—as high as $6 trillion. S&P calls that sum “a debt iceberg with titanic credit risks.” Local governments have often done the heavy lifting on growth-stimulating infrastructure spending, but with so much debt, that role is reaching its limits.
China is dealing with another feature of a financial crisis: capital flight. Because of strict controls, money can’t gush out as it probably would under a less restrictive regime. But it ends up overseas anyway. Chinese have topped the list of foreign buyers of U.S. residential real estate for six consecutive years, according to the National Association of Realtors. In the 12 months to the end of March, they snapped up more than $30 billion worth of American homes. Canadians purchased only a third as much; Brits and Indians, a quarter each.
In theory, the Chinese-style financial crisis has advantages over the run-of-the-mill sort. By maintaining growth and employment, Beijing is buying time to fix the system. Regulators are attempting some sort of cleanup: Corporate defaults were up sharply last year. In reality, the government is perpetuating the crisis by taking out the financial garbage much too slowly. What’s probably required is a massive overhaul of bloated state-owned enterprises. Even worse, policymakers keep adding refuse to the pile. They remain fixated on achieving growth targets impossible to reach without infusions of more credit. China is a debt junkie, and like any addict, it needs a fix—of credit—to keep going. When that short-term relief wears off, the economy begins to slow down again. Chinese leaders get the shakes, lose their determination to tackle the debt, and inject another hit of credit.
They’re trying it again. Much of the recent slowdown results from government efforts to constrain debt. So policymakers are, as usual, turning the credit spigot back on. In early January the central bank reduced the amount of cash it mandates banks hold in reserve, allowing them to lend more. Inevitably, that means more bad loans. “More debt is generated, and that debt is used to create all the things that have caused the problem over the past decade,” says Dinny McMahon, author of the book China’s Great Wall of Debt.
In that sense, the government is making the financial crisis with Chinese attributes worse than a standard crisis. Lehman moments might be terrifying, but they’re also cleansing, an opportunity for the market to scrub out the bad stuff and clear room for new, good stuff. Beijing, by stopping that from happening, is allowing the waste to rot and fester, likely enlarging the costs of the unavoidable cleanup.
Eventually the state will have to step in and fix the mess, just as the U.S. government did in 2008. China’s banking repair will likely require the mother of all Troubled Asset Relief Programs. We can get a rough idea from past crises of how big the bill might be. South Korea’s government spent the equivalent of 31 percent of national output repairing its financial system in the wake of the 1997 crisis. Applying that as a guide, China’s tab could reach $3.8 trillion. It could be even higher. Indonesia coughed up 57 percent of its gross domestic product in its post-1997 restructuring.
Meanwhile, the economy is weighed down. Too much of China’s debt has been amassed in unproductive ways—unnecessary factories, insolvent “zombie” companies—and that gross misallocation of resources is eating away at key drivers of growth. The New York-based Conference Board, a research association, figures total productivity growth in China has been negative since 2012.
All this leads to a downward spiral. With the nation already buried in debt, each attempt to stimulate the economy with fresh credit has a smaller and smaller payoff. As research firm Fathom Consulting explainedin an October study, China’s old economic model “is exhibiting diminishing marginal returns.” There are signs of that happening. Despite months of prodding lenders, credit growth has not picked up steam as policymakers have wished. Heightened anxiety over the economy combined with the already staggering level of debt is making it more difficult for the government to rely on additional credit to keep China growing.
Perhaps there will come a point where even Chinese policymakers recognize that the debt is so dangerous that controlling it must take precedence over growth. It’s difficult, though, to imagine what will wake them. Higher inflation could be a game changer, since that would make it more challenging for the central bank to keep pumping in the cash the system needs to stay afloat. But that isn’t in the cards, at least in the short term. A sharp drop in inflation is raising concerns that China might enter a deflationary period that would make its debt an even heavier burden to bear.
The only real solution, as McMahon notes, is “changing the way the economy grows.” Economists and policy wonks have argued for eons about China’s need to “rebalance”—shift its growth engine from investment to consumption. That’s not happening quickly enough. Each time the government uses debt to prop up growth, it’s a setback for reform of the economic system. Beijing, according to London-based Fathom, is “avoiding the economic realities of rebalancing while storing up problems for the future.”
The underlying issue is that the liberalizing reforms that could set the economy on a healthier track have all but evaporated, and there’s no revival on the horizon. President Xi Jinping’s top priority is imposing Communist Party control on everything, so he’s kept the state-led, investment-heavy economic agenda that’s at the heart of this characteristically Chinese financial crisis. His latest industrial policies may aspire to fancier products—robots, microchips, electric cars—but they could create the same old mess: too many factories, too much debt, too much waste.
Even if Xi’s approach gives birth to new sectors and growth, that won’t necessarily undo the harm already done. The bad loans won’t magically transform into gold. The only real difference between a regular financial crisis and a financial crisis with Chinese attributes is the duration. Most normal financial upheavals last months; China’s may drag on for years. As the world’s premier emerging economy, the People’s Republic should be a source of succor to a slipping world economy. But until it finally resolves its financial crisis, China will instead remain a source of global stress.
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