Beijing reforms race rising debt

Zhou Xiaochuan, Governor of the Peoples Bank of China (PBOC), Chinas central bank, answers a question at a press conference in Beijing, China. (AP photo)

2014 will be year zero for China’s bold reform plan. It will also be the year that will test the country’s tradition of defying doomsayers.

The Chinese government wants to pursue two set of conflicting goals this year: implementing the bold reforms unveiled at the Third Plenum last year and managing the country’s ballooning debt problem.  

Let me explain why these two goals are irreconcilable, at least for the short term.

Beijing’s well-crafted reform plan, if implemented, will set China on the path to grow into a more sustainable and innovative economic superpower. The plan calls for greater openness towards foreign companies, more innovation, reducing regional disparity and a level-playing for privately-owned companies.

The Central Economic Work Conference held in December identified “resolving risk associated with local government debt” as one the top priorities for Beijing this year. Local government debt grew at nearly 20 per cent every year since 2010, according to a recent government audit.

Both objectives are crucial to China’s long-term success, but will create enormous short-term tension. China’s recent economic growth has been achieved on the back of unprecedented expansion of credit and especially in the aftermath of the massive 4 trillion stimulus package. 

To rein in China’s debt problem, which has financed the country’s massive infrastructure spending, will be akin to withdrawing drug from a heroin addict. It will be good for his long-term benefit but will provide a shock to his system initially.

How to achieve a delicate balance between creating new economic growth engines and managing the country’s debt problem will be the biggest challenge facing the Chinese economy in 2014.

Just how bad is the debt problem?  China’s debt-to-GDP ratio, which includes government, household and corporate sectors, increased from 145 per cent in 2008 to nearly 200 per cent in 2012 according to JPMorgan’s calculations.

Zhu Haibin, chief China economist of the American bank, argues the most troublesome sector is not local debt government debt but the heavily leveraged Chinese corporate sector, which has a debt-to-GDP ratio of 125 per cent. That is one of the highest in the world among major economies.

It also shows how fragile some of these companies are. Research modelling predicts nearly half of China’s companies will be in the red when economic growth dips below 7 per cent, according to Liu Shijin, vice minister of the Development Research Centre of State Council (Is 7 per cent China’s new normal? 21 January).

How far would Beijing go to rein in its runaway debt problem this year? It seems unlikely that it will put its foot on the brake too hard. Otherwise, it may send such a shock through the system that the economy is not yet ready to absorb.

All signals suggest Beijing will emphasise stability over aggressive action to crack down on debt. The National Development and Reform Commission says the country aims for 7.6 per cent growth this year.

Li Keqiang, the Chinese premier who is largely responsible for running the country’s economy, has also repeatedly emphasised the need to grow at 7 per cent to maintain employment and ensure social stability.

It is most likely that the Chinese central bank prefers to use steady-as-she-goes Chinese medicine to treat the debt illness over more aggressive Western surgical operation. Zhu of JP Morgan says the Chinese central bank has been engaging in its own credit tapering since April last year, which sent inter-bank borrowing rates sky-high temporarily.

It is clear that Beijing wants to control the expansion of credit and manage the growth of debt, but not so aggressively as to upset the apple cart. The growth of shadow banking industry is also making it more difficult to put a lid on the expansion of credit.

So a race is on between structural economic reform and debt crisis. And the time is not on the side of China.

 Sure, it can still manage to grow at 7 or so per cent for the next few years – especially given that key export markets like the US are recovering.

But it always takes longer for the benefits of reform and productivity gains to be realised than for debt crisis to implode with little warning. China must not waste this crucial window of opportunity to steer the economy in the new direction.