The recent financial turmoil in China, with interbank loan rates spiking to double digits within days, provides further confirmation that the world's second-largest economy is headed for a hard landing. Fuelled by massive credit growth (equivalent to 30 per cent of GDP from 2008 to 2012), the Chinese economy has taken on a level of financial leverage that is the highest among emerging markets. This will not end well.
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.