China's slowdown has further to go

I don’t think China is yet heading towards an economic crash, but I do think that even current growth rates are too high, and sell-side researchers and the various official entities in China and abroad will continue, as they have in the past, to revise their growth numbers downward almost on a quarterly basis.

And because growth will consistently underperform expectations, many members of the Chinese policymaking elite, and their effective allies among the shrinking but still large contingent of China-bulls, will increasingly argue that the economic rebalancing is being mismanaged, thereby putting pressure on Beijing to go into reverse. This is the real risk. There is no way that China can rebalance its economy even at growth rates of 6-7 per cent, and attempts to keep growth above that level will simply mean that it will take much longer for China to fix the underlying problems in the economy, that the costs will be much greater, and that the risk of a disorderly crisis will increase.

So far Beijing has done a great job in resisting this pressure to backtrack. The increasingly nasty trade spats between China and Europe and between China and the rest of the world, including the US, may make it harder for Beijing to pull off the necessary reforms, but so far they haven’t. It would probably be in everyone’s best interests if policymakers on both sides worked hard to tone down the rhetoric, but as I have been arguing for many years, I think trade disputes are only going to get worse, not better. If Europe and the US truly want to help Beijing transform the Chinese economy into something more stable for China and better for the world, they should create a little more space in the external sector in which Beijing can maneuver.

This process of slower-then-expected growth has been confirmed by the latest set of economic numbers coming out of China last week, which shows that China’s economy is indeed continuing to slow faster than expected as Beijing struggles to get its arms around credit expansion. 

Credit expansion continues to be much too rapid. The good news of course is that credit growth is slowing, but we must put this slowing credit growth in context. Total social financing rose by 1.2 trillion renminbi in May, which is roughly 2.3 per cent of GDP. This of course is much better than the 3 per cent of GDP by which TSF rose during the first four months of the year, but the consequence is likely to be an increase in GDP of about 0.6 per cent. Credit growth of 2.3 per cent of GDP (and this does not include credit growth which occurred outside TSF, such as leasing and shadow banking, which may add another 0.5-0.6 per cent of GDP) generated, in other words, roughly one quarter of that amount on GDP growth. Even this GDP growth is not necessarily real growth – it depends on how much of this activity was genuinely wealth creating and how much was simply caused by more wasted investment.

Can China spend its way to growth?

This is way too much debt, and it continues to imply that real debt servicing costs are growing much faster than the debt servicing capacity. Clearly this cannot be sustained. There are still bulls out there who insist that China is out of the woods and making a strong recovery, for example former deputy governor of the Reserve Bank of Australia, Stephen Grenville, who argues in his article (Sages fall flat when chiding China, May 22):

The missing element from the low growth narrative is that unemployment would rise, provoking a stimulatory policy response. China would extend the transition and put up with low-return investment (recall that when unemployment was the issue, Keynes was prepared to put people to work digging holes and filling them in) rather than have unemployment rise sharply. To be convincing, the low-growth scenario needs to explain why this policy response will not be effective.

It seems to me that the reason why simply “provoking a stimulatory policy response” won’t help China has been explained many times, even recently by former China bulls. Of course more stimulus will indeed cause GDP growth to pick up, as Grenville notes, but it will do so by exacerbating the gap between the growth in debt and the growth in debt-servicing capacity. Because too much debt and a huge amount of overvalued assets is precisely the problem facing China, it is hard to believe that spending more borrowed money on increasing already excessive capacity can possibly be a useful resolution of slower Chinese growth.

Perhaps Grenville is confused by what seems like low government debt and a low fiscal deficit, but these numbers are wholly irrelevant. Most fiscal expansion in China does not occur through the fiscal account but rather through the banking system. In that light recent comments by David Lipton, IMF deputy managing director, are relevant.

Lipton was in China two weeks ago when I had the chance to discuss some of these issues with him, and there is little doubt in my mind that he understands the pressures facing China, especially the growing gap between Chinese debt and its ability to service that debt. He also made clear that he recognises the confusions in the fiscal account. On June 9, during his press conference, in which he warned of the “important challenges” China was facing, he went on to say:

Fiscal reforms are also an integral part of the agenda to support rebalancing, improve governance and raise the efficiency of investment. Including local government financing vehicles, an estimate of the 'augmented' general government debt has risen to nearly 50 per cent of GDP, with the corresponding estimate of the 'augmented' fiscal deficit now on the order of about 10 per cent of GDP last year. While part of this deficit is financed through land sales and the “augmented” debt is still at a quite manageable level, it’s important over time to gradually reduce the deficit to ensure a robust and sustainable fiscal position and debt profile. 

With an “augmented” fiscals deficit already of 10 per cent of GDP (the IMF explains what it means by an augmented fiscal deficit here), and with so much excess investment in infrastructure, real estate, and manufacturing capacity, it probably isn’t necessary to explain a whole lot more why further fiscal stimulus might create growth in the short term but would be harmful for China in the medium term.

The slew of economic data released last week will have been much discussed and analysed in the media so I won’t add much more than I already have. Yes, Chinese growth is slowing, but by now this cannot have been a surprise to any but the most determined of bulls. The small possible uptick in retail sales might imply slightly stronger household consumption growth, but this is nowhere near enough to compensate for the decline in the growth of fixed asset investment.

Michael Pettis is a senior associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management. He blogs at China Financial Markets.