China
China Slide Toward Debt-Deflation Trap Needs 5-Year Plan Fix
Bloomberg News November 2, 2015 — 3:01 AM AEDT
Updated on November 2, 2015 — 12:53 PM AEDT
VIDEO: HSBC's Zhu Sees One More Rate Cut from China This Year
* Structural overcapacity risks overpowering cyclical fixes
* Need to close 'zombie' companies, unleash new growth drivers
As China’s Communist Party leaders began rolling out a blueprint last week to manage a transition to more balanced growth over the next five years, they confront the immediate task of halting the economy’s slide toward a debt-deflation trap.
The central bank stepped up efforts last month to avert that risk with a sixth interest-rate cut in a year. While easier policy helps tide over the short term, a long-term fix needs leaders to back reforms in the 13th five-year plan that slash excess industrial capacity, rev up new growth drivers and shift funding away from deadbeat state companies to vibrant private ones.
China’s total outstanding borrowing has surged by two-thirds since 2008 to 208 percent of gross domestic product, producer prices have slumped for 43 consecutive months and the consumer price index began a downward trajectory in the middle of last year. The risk is a vicious downward spiral that traps companies as their assets lose value at the same time as real financing costs rise, forcing them to borrow more to stay afloat in a cascading downward plunge.
"While monetary easing can help and is necessary, corporate and state enterprise reforms are critical," said Wang Tao, a China economist with UBS Group AG in Hong Kong. "To fundamentally address the issues, China needs to embark on more structural reforms to unleash new sources of growth, to retire excess capacity and close "zombie" companies and write off bad debt on banks’ balance sheets."
Underscoring sluggishness in China’s old growth drivers, the official factory gauge signaled that manufacturing contracted for a third straight month. The purchasing managers index remained unchanged at 49.8 in October, the National Bureau of Statistics said Sunday, below the median estimate of 50 in a Bloomberg survey. A gauge of prices manufacturers expect to pay decreased to an eight-month-low of 44.4, NBS said. Readings under 50 indicate below-trend growth.
A separate purchasing managers’ index from Caixin Media and Markit Economics improved to 48.3 in October. That beat the median estimate of 47.6 in a Bloomberg survey and rose from the final reading of 47.2 in the month earlier.
Premier Li Keqiang has signaled China needs minimum growth of about 6.5 percent per year through 2020 to meet the goal of becoming a "moderately prosperous society." That could indicate the leadership’s readiness to accept the weakest period of expansion since the economy was opened up more than three decades ago.
Lower Target
Lowering the growth target to 6.5 percent would reflect the difficult economic transition underway as China shifts its growth toward services and higher value-added manufacturing and as "significant and sometimes painful structural reforms are needed," said Rajiv Biswas, Asia-Pacific chief economist at IHS Global Insight in Singapore.
Whether China can deliver that pace of growth depends on how much financial, state enterprise and land reform it can bring about, said Larry Hu, head of China economics at Macquarie Securities Ltd. in Hong Kong. Financial reform will increase volatility dramatically and state-owned enterprise reform and land reform will take on the two most powerful groups in China: state companies and local governments, he said.
"These are politically difficult and very risky reforms but they are needed for China to find new growth engines," said Hu. "All the old growth engines are dead. This year, export growth is zero, property investment is zero, heavy industry and commodity producers have slumped."
Policy makers should reduce debt by allowing thousands of heavily indebted and unprofitable enterprises to go bankrupt, says Victor Shih, a professor at the University of California at San Diego who studies China’s politics and finance.
"China has chosen to continue to inflate the debt bubble and to generate growth," he said. "But no country can do so forever."
Shuttering inefficient state companies producing losses and now being kept afloat by favorable credit terms will free up capital for more profitable companies to expand, said Julia Wang, a Hong Kong-based economist with HSBC Holdings Plc in Hong Kong.
So far, the central bank’s efforts to counter the risk of debt deflation have come up short. Former central bank adviser Yu Yonding says China is repeating mistakes it made in the 1990s, when it eased too little, too late, leaving producer prices in negative territory for almost three years.
HSBC’s Wang agrees, saying the central bank has been "behind the curve" as it prioritized reining in debt. Should growth fail to reverse its downward momentum this quarter, she says it would take a "circuit breaker" of as much as a 300 basis point reduction in banks’ required reserve ratio, along with an explicit government statement saying it will front-load infrastructure investment to turnaround negative expectations about deflation and growth.
"It takes time for the cost of debt deflation to appear via the shrinking of the balance sheet and the risk aversion of the banking system," she said. "It leads to another leg down in demand, and so on, in a downward spiral."
Monetary Firepower
In the short term, China retains a big monetary arsenal to help counter downward pressure on the economy. The benchmark one-year lending rate is by comparison with western nations still high at 4.35 percent, and it has about 23 trillion yuan ($3.6 trillion) in bank deposits locked up as reserves.
Such ammunition may enable China to "muddle through" for a long time but will not prevent growth from grinding down to an average of about 5 percent per annum to 2020, says Andrew Polk, an economist with the Conference Board in Beijing. And cutting interest rates actually risks exacerbating deflation because the outcome will be more funds flowing to state enterprises that build additional excess capacity, pushing prices even lower, said Polk.
"Right now the structural problem of overcapacity is overpowering the cyclical fixes they are using to address demand," he said ahead of the release of five-year plan communique. "We just see a long-term deceleration because of the stalled reform program."
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