China has too much debt.
There are few areas in economics that pretty much everyone agrees on, but this is one of them.
The level of debt the country is carrying puts it at risk of a 2008-style shock or Japanese-style perma-deflation.
So it should be good news that Chinese leader Xi Jinping has said that he wants to crack down on leverage. And it is.
Trouble is, while curing China’s debt addiction is a worthy long-term goal, it’s hard to see how it can avoid incurring short-term pain to get there…
You can’t get there from here
As Diana Choyleva of Enodo Economics puts it, China’s “debt to GDP is approaching uncharted territory and the authorities can no longer sweep bad loans under the carpet”.
At a whopping 210%, private sector, non-financial debt in China is now higher (as a percentage of GDP) than it was in Korea ahead of its 1997 crisis, and it’s nearly at the levels seen in Japan ahead of the 1989 bubble and bust.
So it would be better for China if its debt position were a little less precarious. The multi-trillion-yuan question, of course, is: “how do you get there from here?”
Credit makes the world go around, as Liza Minnelli didn’t quite put it. The problem is that, in general, the more debt you have, the more you have to spend for every $1 of genuine growth. If you don’t have much debt, then adding a little can really juice up your returns. But if your economy is already swamped with it, you have to add a lot to get just a little extra growth.
China is still growing rapidly. But its growth rate has halved from its pre-financial crisis levels. And the risk is that just throwing further money at the problem spurs inflation rather than helping growth.
For example, notes Choyleva, the Chinese government “stimulated” the economy at the start of 2016 (partly in response to the fear rattling markets at the time). “Growth surged in the quarter, but house price inflation picked up speed immediately.”
The good news is that “Beijing understands that putting off dealing with bad loans and using banks… to bankroll spending sprees… will no longer work”. The bad news is that, even in a system where the banks are basically just arms of the government, it’s not easy to engineer a “soft landing”.
The plan is to clean up the system by allowing capitalism to creep into the process. Monetary policy is being tightened. Some over-indebted companies will be bailed out, but others will be allowed to fail.
Of course, that’s easier said than done – akin to “changing the engine while the car is still running”, says Choyleva.
As UBS analysts put it: “it could lead to a rise in credit events, excessive liquidity tightening, faster-than-intended slowdown of credit growth, and greater market volatility”.
Markets are showing early signs of concern about China
None of this should come as a surprise. Of course it’s difficult to unwind a centrally planned economy in favour of something more market-orientated. Particularly when you simultaneously want to maintain a pretty tight grip on the social reins.
If you are under any illusion that this should be easy, just think how jittery our own “free market” economies get every time our premier economic planning institutions – the central banks – threaten the teensiest little interest rate rise, or a gentle slowdown in the rate of money printing.
Our policymakers reckon they have a lot of balls to keep in the air. But China is juggling with fiery chainsaws by comparison.
An overvalued exchange rate. Capital flight. A state-owned banking system choked with bad debts from state-owned corporations. A shadow banking system full of high-risk investment products used mostly by members of the Communist party, who would be very unhappy about a systemic collapse wiping out their investments.
Trying to reform all that lot without any sort of upheaval is downright impossible.
Markets are only just waking up to this. Miners and commodities had an amazing year last year, but prices have started to come off the boil. Commodity prices are slipping back, the mining sector peaked in February, and of course, oil prices are on the slide again.
Not coincidentally, the Shanghai Composite Index has been slipping back over the past fortnight. Simon Derrick of BNY Mellon tells the FT: “While the forces driving the recent equity market weakness in China and oil are seemingly unconnected, it’s nevertheless noticeable that the major turning points for both have tended to coincide over the past two years.”
So what’s next? On the one hand, commodities and the mining sector came a very long way in 2016. It’s no surprise that they might need a breather.
On the other, if there is another panic over China – and it feels as though one is brewing – then there could be further declines to come. And there’s no doubt that a lot of the “excess” money in the Chinese system has gone into commodity stockpiling and property speculation.
Of course, if fears over China rear up again, the rest of the market will have to catch up with the commodities sector. In short, we might get some interesting opportunities arising before too long.