Why China's crunch is serious this time

Over the past five years, it has been the faltering advanced Western economies creating heartache for global markets, and fast-growing developing giants in Asia seemingly coming to the rescue. This time, it has been China’s credit crunch that has got Australian and global markets spooked. Although it seems to have been somewhat alleviated for the time being, pundits are divided on whether it signals the painful beginning of a fruitful reform process, or whether China’s much-touted authoritarian model is losing its touch. The perhaps unsatisfactory answer is that it is a bit of both.

So should it be a glass-half-empty or half-full viewpoint? My position would be this: despite the presence of some very competent technocrats in Beijing, history shows that the experience of large and complex economies trying to manufacture a slowdown in lending after periods of credit excess rarely ends well for them.

First of all, let’s recap what happened. In early June, data for May indicated a slowdown in construction and manufacturing, while exports posted their lowest growth at 1 per cent over a year. This was reflected in the imports of major metals such as copper and alumina falling at double digit rates, while energy usage such as coal also dropped sharply. In April, housing sales declined sharply. Figures for April revealed that new homes sales in Beijing fell over 57 per cent compared to the month before, while sales in pre-owned homes fell 88.1 per cent compared to the month before.

The standard analysis that China could miss its growth target of 7.5 per cent for the year by a few basis points was disappointing but hardly cause for concern. In reality, growth has been far lower. Even Premier Li Keqiang once admitted a few years back that official growth numbers were ‘man-made’ (read ‘made up’) and could not be believed. Historical forensic analysis consistently shows that the most reliable indicator has been electricity usage, with 85 per cent accuracy in indicating actual growth rates for the country once economists and accountants pour over old and revised data. Worryingly, electricity usage in May grew at around 2.9 per cent.

In the past, such slowdowns would cause Beijing to instruct its banks to further loosen credit, as occurred from 2009-2010 when the outstanding loan books of Chinese banks expanded by 58 per cent in a mere two years. For admirers of ‘capitalism with Chinese characteristics’, this was the advantage that authoritarian China had over Western economies: the capacity for immediate and decisive action.

This time, central authorities did not respond in the same way. President Xi Jinping demanded that the central and lending banks attack the ‘four winds’ of ‘formalism, bureaucracy, hedonism and extravagance.’ (Translations from Mandarin Chinese to English can sound somewhat obscure and antic.) Although President Xi’s exhortation applied to corruption within the Chinese Communist Party, it also refers to reining in excess credit which has ballooned from 120 per cent of GDP five years ago to 200 per cent currently.

Central authorities were sending a message to the country’s banks: over-rapid credit expansion would not be tolerated. Although it has the cash to do so, central authorities instructed the central bank to refrain from injecting cheap capital into the commercial banking system. The seven-day repo rate (repossession or repo rate is the interest of capital charged by the Central Bank to commercial banks) jumped from 2.78 per cent in mid-May to over 10 per cent in mid-June. The overnight repo rate ended on 25 per cent on June 20 having reached 30 per cent at one stage, effectively freezing this avenue of funds for banks. Subsequently, interbank lending rates (what commercial banks lend to each other) breached 13 per cent in mid-June in the highest ever recorded levels. Starved of cash, several banks also defaulted on their interbank obligations, creating a mini-panic amongst the country’s banks. There were fears that this could be China’s Lehman Brothers moment.           

The central bank finally relented, allowing the seven-day repo rate to fall back into single digits, even though it remains more than double what it was in May. Fears of a catastrophic ‘credit crunch’ have subsided for the moment but the brakes on credit growth have been clearly applied.

The curious thing about all this is that, ostensibly, it was an engineered liquidity crunch. Why did Beijing do it, and what happens from here on?

Beijing is concerned about two related things. The first is the explosion in credit growth, especially since 2009, resulting in a surge of unneeded and wasteful fixed investment. I have written about this several times in previous columns. (For example, see China grasps for a growth alternative, September 3, 2012.) As another indicator of investment inefficiency or capital factor productivity, every $100 lent now generates only $17 in GDP, falling from $29 in 2012 and $83 in 2007.

The second and related problem is the shadow banking system. So-called ‘shadow’ lenders get money by borrowing it from traditional banks, and also raising it from wealthy individuals wanting a higher return on their capital. These lenders then issue loans that would not suit the traditional risk profile for normal commercial and retail bank lending – at substantially higher rates. Financial vehicles to facilitate such lending include trusts, insurance firms, leasing companies and pawnbrokers. Given the decade of easy money, almost every type of corporate entity is involved in setting up these vehicles: from large and small banks, SOEs, large private corporates and local governments.

It is no wonder that central authorities want to crack down on this kind of activity. According to JP Morgan Chase estimates, the debt issued by the country’s shadow banking sector has grown from about $US2.9 trillion in 2010, to $US4.3 trillion in 2011, to about $US5.7 trillion in 2012. The common argument that Chinese financial system is not a heavily leveraged one clearly only looks at standard ‘vanilla’ loans.

Beijing has tried to clamp down on the high-risk shadow banking sector, considering it a systemic risk to the whole financial system and economy, though directives on allowable risk profiles for loans. The problem is that these alternative investment vehicles mentioned above are set up precisely to circumvent such directives and conceal risky lending from regulatory authorities, meaning that Beijing has had little success. In a desperate move, the engineered credit crunch is a blunt policy instrument that is designed to limit the amount of excess funds available that can be (mis)directed to the shadow lending sectors.

This is why some have applauded the move and see it as further sign that enlightened technocrats that rule the roost in the CCP. Of course, this viewpoint ignores the fact that the CCP’s refusal to liberalise interest rates and allow them to rise and fall according to market signals, is largely behind the problem in the first place. Remember also that ‘capitalism with Chinese characteristics’ encourages lending to inefficient SOEs rather than far more enterprising private firms, leading to deterioration in loan quality that is masked up by temporary technical fixes such as forced rollover of maturing loans and increasing new loan volume, in order to lower the official proportion of non-performing-loans on the books.

But even as a short-medium term technical fix, the risks of suddenly tightening liquidity are considerable.

For a start, many private firms starved of formal finance are forced to resort to the shadow banking system. The private sector in China is not just more efficient but is also more innovative than SOEs. Around four-fifths of all patented innovations in the country are from private firms, despite the domestic disadvantages they face. Killing shadow banking will kill off many private firms, and entrench the dominance of SOEs in many sectors even more.

Then there is the matter of the speculative high-end residential housing sector. On the one hand, buying and selling housing based purely on expectations of high capital growth that is completely divorced from rental yield return always ends in tears. But housing assets at inflated prices are widely used as collateral for further debt. Returns from residential construction projects are relied upon by local governments as a fiscal revenue raising measure, and to pay back outstanding loans. In 2011-12, an estimated $US1.7 trillion of maturing loans to local government financial vehicles were forcibly rolled over by the central government so that these local government owned entities would not be in default – and this was before the current credit crunch.

Turning off credit will lead to defaults, and the unbelievable NPL ratio of around 1 per cent of outstanding loans will be exposed as an illusion. Illusions are unhealthy and ultimately unsustainable in any financial system. But there is rarely a good time to expose them – especially when so much growth has occurred on the back of it.  

The point is that pricking asset bubbles and reining in credit after a period of excessive growth can lead to unintended consequences, however necessary it is to do from a macroeconomic point of view. In doing so, Japan suffered two decades of stagnation and America is only just tentatively recovering. The difference is that systems in industrialised economies can survive long periods of economic stagnation without great social and political turmoil.

China’s technocrats in the central government need to tread carefully. Some might still believe that authoritarian China has its advantages. But if there is a sustained period of economic stagnation, social and political resilience is not one of them.          

Dr John Lee is the Michael Hintze Fellow and adjunct associate professor at the Centre for International Security Studies, Sydney University. He is also a non-resident senior scholar at the Hudson Institute in Washington DC and a director of the Kokoda Foundation in Canberra.