High political stakes as Chinese economy faces hard landing
Indeed, a recent study by Nomura Securities finds that China's financial-risk profile today uncannily resembles those of Thailand, Japan, Spain, and the US on the eve of their financial crises. Each crisis-hit economy had increased its financial leverage - the ratio of domestic credit to GDP - by 30 percentage points over five years shortly before their credit bubbles popped.
Economists who insist that China's financial leverage is not too high are a dwindling minority. The People's Bank of China, which engineered a credit squeeze in June to discourage loan growth, seems to believe that financial leverage has risen to dangerous levels. The only questions now concern when and how deleveraging will occur.
At the moment, China watchers are focusing on two scenarios. Under the first, a soft economic landing occurs after China's new leadership adopts ingenious policies to curb credit growth (especially through the shadow banking system), forces over-leveraged borrowers into bankruptcy, and injects fiscal resources into the banking system to shore up its capital base. China's GDP growth, which relies heavily on credit, will take a hit. But the deleveraging process will be gradual and orderly.
Under the second scenario, China's leaders fail to rein in credit growth, mainly because highly leveraged local governments, well-connected real-estate developers, and state-owned enterprises successfully resist policies that would cut off their access to financing and force them into insolvency. Consequently, credit growth remains unchecked until an unforeseen event triggers China's "Lehman" moment. Should this happen, growth will collapse, many borrowers will default, and financial chaos could ensue.
Two intriguing observations emerge. First, drastic financial deleveraging is unavoidable. Second, Chinese growth will fall under either scenario.
What impact will an era of financial deleveraging and decelerating growth have on Chinese politics?
Most would suggest that a period of financial retrenchment and slow GDP growth poses a serious threat to the Chinese Communist Party (CCP), which is based on economic performance. Rising unemployment could spur social unrest. The middle class might turn against the party. Because economic distress harms different social groups simultaneously, it could facilitate the emergence of a broad anti-CCP coalition.
The people who should be most concerned with financial deleveraging and slower growth are President and CCP General Secretary Xi Jinping and Prime Minister Li Keqiang. If the deleveraging process is quick and orderly, they will emerge stronger in time for their reappointment in 2017.
Minxin Pei is professor of government at Claremont McKenna College and a non-resident senior fellow at the US German Marshall Fund. © Project Syndicate, 2013. project-syndicate.org
Frequently Asked Questions about this Article…
A 'hard landing' means a sharp slowdown in China's economic growth rather than a gradual deceleration. The article highlights recent financial turmoil — such as interbank loan rates spiking into double digits and very high credit leverage — as signs that China may be headed for a hard landing, which could hurt growth, trigger defaults and create wider financial stress.
Interbank loan rates jumped to double digits within days, a clear sign of stress in China’s financial system. According to the article, such spikes suggest banks are short of liquidity or reluctant to lend, and they reinforce concerns about elevated leverage and an imminent deleveraging process.
Between 2008 and 2012 China’s credit growth was equivalent to about 30% of GDP, driving domestic credit-to-GDP to levels that the article says are the highest among emerging markets. Rapid credit growth like this raises the risk of an unstable financial system and makes a painful deleveraging more likely — a key risk for investors with China exposure.
The Nomura study cited in the article finds that China’s financial-risk profile resembles those of Thailand, Japan, Spain and the US just before their financial crises. Each of those economies increased domestic credit-to-GDP by roughly 30 percentage points over five years before their credit bubbles popped, suggesting similar vulnerability in China.
The article outlines two scenarios: a soft landing where new leadership curbs credit (including shadow banking), allows over‑leveraged borrowers to fail, and injects fiscal support so deleveraging is gradual and orderly; and a failure to rein in credit where local governments, property developers and state-owned enterprises block reforms, leading to unchecked credit growth until a sudden ‘Lehman’‑style shock causes a collapse, mass defaults and financial chaos.
Yes. The article argues that drastic financial deleveraging is unavoidable and that Chinese growth will decline under either scenario — a measured hit in a soft landing or a sharp collapse if a systemic shock occurs.
Financial retrenchment and slower GDP growth could threaten the Chinese Communist Party’s legitimacy, the article warns. Rising unemployment and economic distress could alienate the middle class and other groups, possibly fostering broad anti‑CCP sentiment. The article specifically names Xi Jinping and Li Keqiang as the leaders most directly affected by the success or failure of deleveraging, with implications for their reappointment in 2017.
The article suggests watching interbank loan rates (liquidity stress), overall credit growth and the domestic credit‑to‑GDP ratio, signs of trouble in the shadow banking system, People’s Bank of China policy moves (such as credit squeezes), and pressure from highly leveraged local governments, real‑estate developers and state‑owned enterprises — all of which signal the pace and severity of deleveraging.
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