Tuesday, April 3, 2012

Satyajit Das: China's credit-fired return to growth was no miracle and it won't last

China's recovery from the initial effects of the global financial crisis was no miracle. Like the rest of the world, it was the result of "Botox economics". Taking advantage of a centrally controlled, command economy, Beijing boosted output through government spending and directed bank lending to maintain growth. According to the World Bank, almost all of China's growth since 2008 has come from "government-influenced expenditure".

But as Chinese growth slows, Beijing's options to re-ignite strong growth are increasingly constrained. The weakness of its two major trading partners, the US and Europe, means that China cannot rely on export demand to drive growth. Domestically, the side effects of debt-driven investment are now emerging.

China's use of rapidly increased credit to restart growth after the global financial crisis has taken the volume of credit outstanding to 130 to 140 per cent of GDP and to as much as 160 to 170 per cent when off-balance-sheet lending is included. Increased lending created asset bubbles in property and shares, both of which are now unwinding.

Cash flows from many investments will be insufficient to cover all the debt, increasing the volume of non-performing loans in the banking system. The governor of the People's Bank of China (PBOC), Zhou Xiaochuan, observed candidly that the large credit flows "pose bank lending quality risks". Resolving the bad debts will absorb a significant portion of Chinese savings and income.

China is also left with a legacy of low-return investment, for example in infrastructure, which will create a drag on growth.

The efficiency of Chinese investment has fallen. One measure is the incremental capital-output ratio (ICOR), calculated as annual investment divided by the annual increase in GDP. China's ICOR has more than doubled since the 1980s and 1990s, reflecting the marginal nature of new investment. Harvard University's Dwight Perkins argues that China's ICOR rose from 3.7:1 in the 1990s to 4.25:1 in the 2000s.

It now takes about $6 to $8 of debt to create $1 of Chinese GDP, up from $1 to $2 only 20 years ago. In the US before the 2008 crisis, it took $4 to $5 of debt to create $1 of GDP.

Specifically, China's capacity for further stimulus is uncertain. The conventional view is that China will be able to continue to stimulate demand using its large foreign exchange reserves, large domestic savings and low levels of debt.

China's $3.2trn (£2trn) in foreign exchange reserves are invested predominately in US dollars, euros and yen, primarily in the form of government bonds and other high quality securities. These assets have lost value through increasing default risk as the issuer's ratings are downgraded and through falls in the foreign currencies against the renminbi.

Any attempt by China to liquidate its reserve assets would result in sharp falls in the value of the securities and a rise in the renminbi. The reserves also force China to buy more US dollar, euro and yen securities to defend the value of the existing portfolio, increasing both the size of the problem and its risk.

In reality, China will ultimately have to write off these reserves and recognise its losses. This equates to a real loss of wealth as China has issued renminbi and government bonds against the value of these investments.

China also has far greater levels of debt than commonly acknowledged, although the bulk is held domestically. The central government has a low level of debt – around $1trn or 17 per cent of GDP. In addition, state-owned and supported entities have debt totalling $2.6trn. The total debt of about $3.6trn represents 59 per cent of GDP.

The debt levels are exacerbated by what Michael Pettis, in his book The Volatility Machine, describes as an inverted debt structure – where borrowing levels increase when the economy has problems. Irrespective of current moderate debt levels, when the economy slows China's debt levels, both direct and contingent, will increase rapidly.

China also has limited flexibility in managing its currency. The renminbi has risen 30 per cent since Beijing adopted a policy of managed appreciation and revalued its dollar peg in July 2005.

As growth and exports slow (the trade surplus has fallen to 2 per cent and foreign exchange reserves are shrinking), China needs to let the renminbi fall to cushion the adjustment. In a US election year, the risk of trade protectionism and the prospect of being referred to the World Trade Organisation for currency manipulation limit China's policy flexibility.

It seems inevitable that China's growth will slow, with only the extent in question. The real question is whether it can manage its transition to lower growth without social upheaval.

Satyajit Das is author of 'Extreme Money: The Masters of the Universe and the Cult of Risk' (2011)


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