China: In the shadow of eight dragons

With growth slowing, will the country continue on the path of debt-fuelled growth or pursue painful structural reform?

Updated - November 28, 2016 08:05 am IST

Published - November 27, 2016 11:02 pm IST

“The biggest problem in China’s economy is that the growth is unstable, imbalanced, uncoordinated and unsustainable.” — Former Premier Wen Jiabao, March 2007

China’s economic achievements are unparalleled in economic history. The country has achieved a 10 per cent annual growth rate over the last 35 years, quadrupled per capita real GDP and lifted more than 600 million people from poverty. The per capita income currently is $8,300 and in purchasing power parity terms, it is close to $14,200.

The one lingering issue is whether growth has been driven by ever-rising inputs of cheap labour and capital or by that elixir of growth, which economists term as “total factor productivity growth.” China’s productivity growth has been falling, especially post the Global Financial Crisis of 2008, when the government had embarked on a massive stimulus and avoided structural reform. With growth slowing in China, the question now is - will China continue on its path of debt-fueled growth or pursue a much-needed but painful structural reform.

Debt build-up

The eight dragons identified in the accompanying chart are potential triggers for a crisis in China. The first dragon is over-investment. The world has been impressed with the infrastructure investments and the rapid transformation of physical infrastructure in China during the last two decades. However, a recent study by the Said Business School (2016) argues that cost overruns and misdirected infrastructure investments account for at least one-third of the massive debt build-up that will likely engender economic and financial fragility.

The second dragon is total debt to GDP. It is worth noting that between 2006 and 2015, the corporate debt has zoomed from $3.4 trillion to $17.8 trillion - a five-fold increase in 9 years. While state-owned enterprises (SOEs) in China have accounted for bulk of the debt taken, private property developers have also borrowed heavily. More importantly, a research conducted by the Bank for International Settlements indicates that the gap of the credit to GDP ratio gap vis-a-vis its long-term trend China is now at 30.1 per cent, more than three times the normal deviation and is a robust early warning indicator of banking crisis.

The third dragon is the inefficiency of the SOEs. There are about 150,000 SOEs with aggregate assets of about RMB 100 trillion ($15 trillion), whose return on assets was only 2.4 per cent compared to 6.4 per cent in the U.S. More importantly, even the largest SOEs are actually loss-making, if the the cost of subsidies that they received are fully accounted for. The fourth dragon is represented by the non-performing loans of the banking sector. Charlene Chu of Autonomous Research estimates that by the end of this year, almost 22 per cent of all loans outstanding will be non-performing, although the official non performing loans as a per cent of total loans is only 1.75 per cent as of March 2016.

The fifth dragon is the shadow credit products estimated at RMB 40 trillion ($6 trillion). These are high risk products that offer yields of 11-14 per cent compared to 6 per cent on loans and 3-4 per cent on bonds. Almost 50 per cent of the shadow credit products are of low quality and are risky.

The shadow credit products account for 8 per cent of banks’ assets concentrated in listed banks (outside of the big four) and unlisted banks and the aggregate exposure is several times their capital.

Increasing dependence on the inter-bank market for mobilising deposits could become a source of transmission of stress in case this market freezes up. In other words, banks must raise retail deposits as dependence on wholesale markets could turn risky. The U.S. experience reveals that only decisive action by the Fed, to force banks to conduct stress tests, disclose it publicly and raise capital, saved the banking system from the brink and ultimately the U.S. economy.

It is hard to imagine a similar speed of response in China in the event of a crisis.

The sixth dragon is the overvalued currency and net capital outflows. In the post global financial crisis period, the current account surplus of China has significantly declined, the overvalued currency led to fears of abrupt devaluation prompting capital outflows. In 2015, the net capital outflows came to $673 billion - about 6.2 per cent of GDP. As per International Institute of Finance (IIF) data, net capital outflows in 2016 till September was $320 billion. Despite capital controls, there has been substantial net capital outflows. As per BIS data, the RMB is overvalued by about 20 per cent. Goldman Sachs strategists are predicting a 12-month Yuan U.S. dollar rate of 7.30. The rate currently hovers around 6.92. While China lacks some of the pre-conditions such as open capital account and deep and liquid financial markets necessary to be a part of the IMF’s Special Drawing Rights (SDR), the inherent tension between the aspirations to internationalise the currency and at the same time to have tight controls domestically will add another layer of uncertainty to the value of its currency.

The seventh dragon is rebalancing. When Premier Wen Jiabao made the comment in 2010, investment and private consumption as a share of GDP were 40 per cent and 38.3 per cent respectively. By 2015, investment increased to 45 per cent of GDP and private consumption was 38.2 per cent of GDP. So rebalancing is still awaited.

The eighth dragon is demographics, the old age dependency which is measured as the ratio of the population that is 65 years or above to the working age population (15-64 years) will increase from 0.13 currently to 0.47 by 2050.

Full-blown crisis

From a political economy perspective, Xi Jinping, the current President, has been recently anointed as “Core” leader and is leaning more toward eradication of corruption domestically, geopolitical adventurism and new-found regional assertiveness of China as against its earlier claim of peaceful rise. Our view is that since the Communist Party has targeted doubling the GDP and GDP per capita by 2020 compared to 2010 levels, it will not settle for low-growth and painful structural reform in the short-term. The significance of 2020 is it also coincides with the 100-year anniversary celebrations of the Chinese Communist Party.

While several international organisations such as IMF and BIS have warned of the dangerous levels of debt in China, we expect a full-blown crisis in the next 18-24 months triggered by busted banks, corporate defaults or a sharp devaluation of the currency to stem massive net capital outflows.

U.S trade sanctions on China could be the ultimate tipping point. A large Yuan devaluation will result in a sudden stop of capital flows to emerging markets and global risk-aversion will rise. As regards its impact on India, a negative feedback loop will likely arise between a falling stock market and a depreciating rupee, with distinct overshooting possibilities. However, there may be an opportunity for India to embark on serious reform now, especially cleaning up the banking sector of non-performing assets and revving up the corporate investment cycle to be better prepared to withstand the heat from those eight fiery dragons that are emerging as a credible threat to China’s sustained economic growth and stability.

Sivaprakasam Sivakumar is MD, Argonaut Global Capital LLC, U.S. and Himadri Bhattacharya is Senior Advisor, RisKontroller Global

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