How debt threatens to undermine China's growth miracle
Gene Frieda says just as termites can undermine the foundations of a building, so local government debt is threatening to fundamentally destabilise an economy that is already slowing
PUBLISHED : Saturday, 22 August, 2015, 9:10am
UPDATED : Saturday, 22 August, 2015, 9:10am
China is trying to extend the term of local government debts so that they could pursue financial stimulus, such building new hotels. Photo: Xinhua
There is no better metaphor for the economic challenge that China is facing than the futuristic architectural masterpiece designed to house China Central Television, the state network. On February 9, 2009 - a few months before the landmark building was to be completed - network officials conducted an unauthorised fireworks display, sparking a fire that consumed a smaller building in the complex, a wedge-shaped tower that Beijing's residents had nicknamed the Termites' Nest.
The fire delayed the completion of the CCTV headquarters until 2012. The Termites' Nest remains unfinished and unoccupied; its structural integrity was destroyed in the fire, and it cannot be torn down for fear of undermining its big neighbour.
The two buildings recall China's increasingly two-tracked economy: a new track based on services and consumption burdened by an old, slower track made up of industries such as steel and mining, which are inefficient and suffer from excess capacity. Straddling both tracks is the country's real-estate market, characterised by massive overcapacity in small and mid-size cities and robust demand in large ones.
The real wake-up call has been the belated effort to sort out local government borrowing and misspending
The problem is compounded by the Chinese leadership's insistence on sticking with high growth targets - 7 per cent at present - and the resulting reliance on credit to produce the requisite output. Because the credit system has been designed around implicit state guarantees, much of the financing is misallocated to the less efficient, highly indebted economic sectors. As a result, the foundations of China's growth miracle are steadily being eroded by a debt overhang that shows few signs of receding.
The government's loss of control over the economy has become increasingly evident. The meteoric rise and then crash in the stock market has left investors rattled. But the real wake-up call has been the belated effort to sort out local government borrowing and misspending.
The National Audit Office's first attempt to estimate the size of local government debt uncovered a stock worth 26 per cent of gross domestic product at the end of 2010. It was 32 per cent of GDP in mid-2013, and the latest study by the Chinese Academy of Social Sciences shows that the debt had jumped to 47.5 per cent of GDP by the end of last year.
In November 2013, President Xi Jinping laid out a reform agenda that sought to increase the role of the market in China's economy. This, it was hoped, would solve the capital misallocation problem that seemed to be leading to an unsustainable rise in debt.
Local government debt became a major test case. Early this year, the central government announced plans to convert local governments' short-term, high-interest bank loans into long-term bonds. In doing so, the central government hoped to alleviate financing constraints on local governments so that they could pursue financial stimulus.
When China's banks baulked at accepting the low yields offered on the new bonds, the goal of increasing the market's role in the economy went out the window. The government forced banks to execute the debt swap. Unsurprisingly, banks suddenly became risk-averse. Local governments discovered that even with an improved liquidity position, banks were reluctant to extend new loans.
Meanwhile, a slump in the real-estate market deprived local governments of their main revenue source: land sales. Thus ensued one of the more shocking developments in modern Chinese economic policymaking: the government's call for stimulus was simply ignored.
China appears to be falling into a trap that it sought to avoid. Its debt problem looks set to worsen as the government neglects its reforms in favour of short-term growth objectives. The drag on the economy will increase as resources continue to be diverted toward keeping inefficient firms alive. Banks will become ever more risk-averse.
The government has sought to increase liquidity by dropping controls on the movement of capital. Doing so not only further undermines its control of the economy, but also creates the risk of a full-blown financial crisis that could engulf its neighbours and other emerging markets. For the moment, with the rising dollar adding to China's economic woes as its currency appreciates sharply against regional peers, the devaluation of the yuan was a fallback on old instincts.
That will not be enough. China's property market is deflating. Its equity markets have been discredited, and its economy seems increasingly sluggish. As a result, the country's vast pool of domestic savings is increasingly looking to move abroad. Relative to its foreign debt and the sheer volume of money that could go abroad, even its US$3.7 trillion in foreign reserves is looking puny.
Debt has a unique capacity to make short work of an economy's foundations. By the time the problem is recognised, it is often too late. To reverse the damage, China will need to focus on debt deleveraging, repair its capital allocation mechanism, and delay the abolition of capital controls. A growth crisis in the next 12-24 months is likely; how bad will be determined by whether the government makes difficult adjustments today or - like Japan in the 1990s - tries to wish the termites away.
Gene Frieda is a global strategist for Moore Europe Capital Management. Copyright: Project Syndicate
This article appeared in the South China Morning Post print edition as The erosion of China's growth
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