China’s slow-motion collapse

China's slowdown has revived the discussion about whether it is heading for a financial crisis akin to the developed world's in 2008. It "looks like an accident about to happen", as Larry Elliott puts it in The Guardian.

Growth has been pumped up in the past few years by a housing bubble and overinvestment in infrastructure. In 2009, the government had induced a surge in bank lending to bolster domestic growth as the global crisis had paralysed export markets. And we have seen what happens to housing and credit bubbles.

At first glance, it seems there's nothing to fret about. State debt is a mere 25% of GDP. But this doesn't take into account local and regional government debt, which would be Beijing's problem in the event of a bust. A top Chinese auditor recently described this kind of borrowing as "out of control". It could be worth up to 40% of GDP.

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Then there's the bank lending in the economy, corporate bonds, and the shadow banking system, the size of which is difficult to gauge. Underground lending could be worth 6% of total bank loans, reckons a 2011 estimate. All told, total credit in China may have reached 198% of GDP by late 2012, up from 125%, reckons credit-ratings agency Fitch.

A Lehman-style crash or a run on the banks seems unlikely in China, says Jamil Anderlini in the FT. The government would be able to round up the heads of all the banks and force them to keep lending to a Lehman equivalent. And as all the banks are owned by the state, a run on a bank would imply a run on all. But the public would have to lose faith in its leaders completely to flee from them, in which case a financial crisis would be dwarfed by a political crisis.

However, a slow-motion collapse may already be underway, says Anderlini. It looks as though bad loans are mounting, prompting banks to roll over or hide them, thus keeping lending high but creating less economic activity. This looks like a repeat of the 1990s, when non-performing loan ratios reached 50% and "zombie banks" kept doling out cash.

Note that the amount of credit needed to generate growth has jumped by about half in the past year or so. Fast-rising credit intensity is "the classic sign of an economy sated on debt", said Ambrose Evans-Pritchard in The Daily Telegraph. "China too will have to deleverage."