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China: A Great Wall of Worry


By Milton Ezrati

The economic and financial risks in China are at once more manageable than much of today’s commentary suggests and, however, more dire. There can be no doubt that the country faces severe problems. Economic growth has slowed, raising questions about the viability of China’s development model, while an overhang of debt, much linked to the so-called shadow banking system and excessive real estate development, threatens financial crisis and outright recession. Though probabilities suggest that China can contain any financial fallout and sustain an acceptable growth path, the consequences of failure would be much worse than today’s popular fears. Failure would, in fact, likely lead to widespread civil unrest, rioting, and, possibly, political instability—prospects that certainly should motivate Beijing to deal effectively with the problems.

Financial Embarrassments
The explosion in debt seems the most acute issue. Up until 2007, credit in China, both public and private, expanded at a pace only slightly faster than the overall economy. But since Beijing eased credit in 2009 to contend with global recession, debt use in China has far outpaced economic growth. The value of all debt outstanding has jumped from 187% of gross domestic product (GDP) in 2007 to about 285% at present—a bit more than the U.S. and other developed economies, but remarkably and troublingly high for an emerging economy. Mexico, for instance, still has total debt levels less than its GDP, while India’s stands at about 125% of its GDP. Even Argentina has overall debt levels of less than 150% of GDP. Adding to this troubling picture is the fact that China’s so-called shadow, or unofficial, banking system has led the debt expansion, growing 37% annually since 2007, and now accounts for about one-third of all Chinese lending.1

To American eyes, it is no doubt particularly ominous that much of this credit expansion has gone into real estate, about 40–45% of it in fact. As in the United States earlier in this century, enhanced credit flows first expanded housing demand and pushed up real estate prices. By 2010–11, Chinese real estate prices were rising 10–15% a year. A building surge followed this demand, also enhanced by easy credit flows from the shadow banking system and also because local authorities used their particular access to the state-run banking system to procure financing for developers. Numerous articles and television specials have documented the overbuilding that resulted. As this burgeoning supply overtook demand, real estate prices first moderated, but more recently have begun to fall, 20% nationally, in fact, over the past 12 months. After the experiences of 2007–09, this picture naturally raises fears of bankruptcies, disruptions in credit flows, and intractable recession.2

Economic Troubles, Too
At the same time, China’s pace of economic growth has slowed. The slowdown reflects in part the real estate bust, but it is more widespread than that. All of it threatens to compound the country’s financial problems.

Clearly, the real estate contraction is a major contributor. The country’s official housing index fell 5.7% in February (the most recent month for which data are available) and 5.1% in January. Perhaps even more worrisome, exports, the historical engine of Chinese growth, have weakened, too. March recorded a 15.0% decline from a year-ago levels. The country’s trade surplus has collapsed. Admittedly, China’s trade figures are highly volatile, and could yet reverse. Still, the poor reading still raises warning flags. Capital spending, too, has hit a snag. An official index of new orders signals slow growth at best, as does China’s own purchasing managers survey. Industrial production rose only 5.6% in March, a major tick down from the 6.8% recorded in February. Against such a background, it is hardly a surprise that the overall economy has disappointed. Real GDP for this year’s first quarter expanded at an annual rate of only 5.3%. Developed economies might well envy such a pace at growth, but it is a major comedown in China, which saw 7.1% growth last year and 7.8% in 2013.3

Slower economic growth certainly makes the debt overhang more of a concern, since it means less of the income and wealth needed to discharge those financial obligations. Were China expanding at the 10–12% annual pace recorded some years ago, today’s debt overhang would look much more manageable than it does now, with growth about half as fast. Perhaps still more ominous, China faces a deflationary threat. Producer price measures have been falling since 2012. To be sure, the latest consumer price index release showed an increase. But at an annualized rate of 1.4%, the figure is less than half the official target of 3.5% and barely more than half the 2–2.5% consumer price inflation recorded this time last year. Should a generalized deflation emerge, the real value of the debt outstanding would rise on an ongoing basis, demanding even more real income and wealth generation to discharge, a situation with significant default threats embedded in it.4

Still, Not Necessarily a Collapse
It would be a mistake, however, to take this picture, ominous as it is, and despair, as some seem to have done. Fundamental considerations make the slow growth look less generally dark than it might seem on the surface, while Beijing has significant resources to contain the situation and powerful reasons to do so.

Certainly, the construction cutbacks, though they have clearly contributed to the overall economic slowdown, carry the seeds of a rebalancing. It will take time, of course, for the supply-demand balance to re-right itself. The overbuilding was massive. Projects will continue to fail and losses will continue to detract from prospects for some time. But at least the correction has begun. Nor does the slowdown necessarily imply a failure in China’s development model. Indeed, it could actually reflect a difficult, though necessary shift in that model. Beijing has long known that export-led growth is unsustainable. Even a decade ago, official economic analyses noted how the economy could not depend on exports indefinitely or the capital spending used to support their growth. Beijing, accordingly, has tried to shift the country’s economic focus toward the naturally slower-growing domestic economy. To the extent that the overall growth slowdown reflects some success in this economic reorientation, it is rather more encouraging than it is ominous. The jury is still out, of course, but recent signs of double-digit retail sales growth, despite the much slower overall figure, do at least offer a tentative sign that perhaps this essential shift is occurring.

Beijing’s ample financial resources need consideration, too. If overall debt in China has blown up, the central government has kept public debt well-contained. It amounts to only 27% of China’s GDP, far less than the 100% in the United States or the 250% in Japan. Beijing could assume all the questionable debt associated with real estate, but its outstanding obligations would rise only to some 75% of GDP, hardly a happy number, but still less of a weight than in most every developed country in the world. Since much of the vulnerable debt lies with local governments, such a transfer would be much less difficult than, for instance, when Washington tried to bolster the U.S. financial system during the subprime crisis. Alternatively, should the economic situation reach a more desperate pass, the enviable state of government finances leaves room for significant fiscal stimulus of the sort China implemented in 2009. Memories of the civil unrest and rioting back then should motivate Beijing to use all its resources without restraint should the situation seem to demand it.5

For the time being, China has decided to address its difficulties with monetary stimulus. The People’s Bank of China, in March, cut its benchmark interest rate, from 5.6% to 5.35%. The rate was 6.0% late last year. The object is to thwart any deflationary tendencies and to stimulate the economy by promoting borrowing, including for real estate purchases, presumably to ease the housing glut. In this regard, China also has eased requirements for borrowers to get a mortgage. In certain contexts, this would seem to invite a return of a destructive real estate bubble. Certainly, such moves would have done so during the American real estate crisis. But in this respect, the situation in China is different. In the United States, the leverage lay with the homeowner, and it would have been foolish to encourage more borrowing on his or her part. In China, the leverage lies not with the homeowner but with local governments and developers. Until recently, homebuyers, by law, had to put down a payment of at least 20% on their first home and 50% on a second home. Encouraging them to use a bit more credit and buy at today’s depressed prices hardly runs the same risk of default that the United States would have incurred during its crisis.6

No matter how one slices and dices China’s situation, it is far from easy or pretty. Likelihoods point clearly to bankruptcies and losses. These, among other considerations, will keep China’s economy growing slower than it otherwise might for some months and quarters to come. Still, given the risk to Beijing should it fail to contain financial pressures and sustain at least present growth rates, there is every reason to expect the government to use its still ample resources to avoid such an outcome. China will certainly go through rough times, as it has now for some time, but it likely will avoid the panic and recession of popular fears, much less the social disaster that would occur were it to fail.