Could China’s credit slowdown lead to a crash?

China's growth has slowed by less than feared. But that was about it for the good news.

Markets took some comfort this week from data showing that China's economic growth slowed by less than feared in the first quarter of this year. GDP growth came in at 7.4% over the first three months of 2014, from 7.7% in the fourth quarter of last year. "However, that was it for the good news," says Socit Gnrale's China economist Wei Yao.

Companies are complaining of a double whammy of rising costs. Wages are surging as the supply of cheap labour from the countryside dries up. Meanwhile, a credit crunch engineered by a government keen to cool lending down has pushed up the cost of borrowing.

As a result, says Keith Bradsher in the International New York Times, finding the funds to finance "everything from raw material to new equipment" has turned into "a crippling challenge for businesses and individuals without the political connections to borrow at regulated rates from the state-controlled banking system".

This drop in lending has been led by the shadow banking system (a term that simply describes any lender that isn't a bank), according to Wei Yao. Lending by trusts (companies that take investors' money then lend it out) has cooled the most, followed by corporate bond issuance by non-financial firms.

"China's credit slowdown seems to be increasingly market-drivennow, due to rising risk aversion among lenders." "Pessimists worry about a catastrophic crash" driven by baddebts and collapsing credit availability, saysSatyajit Das in The Independent.

The optimists insist that "debt levels are manageable because of high growthrates" and that "reform programmeswill ensure a smooth transition", with China "rebalancing its economy from investment to consumption". Both sides are wrong. Defaults will be managed.

"As in a shell game, bad debts will be shuffled from entity to entity." Unfortunately, maintaining this illusion of stability will entail ongoing financial repression', with interest rates kept below the rate of inflation. That will keep households' buying power weak, which in turn will make it harder to encourage more consumption.

In the end, "China's Potemkin economy of zombie businesses and banks will create progressively less-real economic activity".

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