Or Decades of Japan-Style Stagnation?
Last year, $674 billion fled China. This year through March, $175 billion did. The Institute of International Finance, in a report released today, estimated that $538 billion would flee China this year.
Reserves have plunged from $4 trillion in June 2014 to $3.2 trillion as of February. Much of it is illiquid and cannot be used to stabilize the currency. So the IIF said that capital flight could accelerate if Chinese investors fret that the yuan could fall in a “disorderly” manner.
This would have broader ramifications:
A sharp drop in the renminbi would likely spark a renewed sell-off of global risk assets and trigger a flight of portfolio capital from emerging markets.
Moreover, a sharp depreciation of the renminbi could lead to a round of competitive devaluation in other emerging markets, particularly in those with close trade linkages to China.
The report warned that an “important unknown” is the level of currency reserves that the Chinese government considers critical. If reserves drop below that level, authorities might either let the yuan fall sharply or tighten currency controls further, both of which would rattle markets around the world.
Add to this environment the growing fear of bond defaults by Chinese state-owned enterprises. Companies have extended large amounts of loans to each other, and defaults would ricochet through Corporate China.
To stimulate the languishing economy and to paper over the structural problems, overcapacity, over-indebtedness, and the mountain of non-performing loans after years of debt-fueled malinvestments, Chinese authorities decided to go on a historic credit binge.
In the first quarter, total domestic and foreign debt, according to calculations by the Financial Times, ballooned by 6.2 trillion yuan ($954 billion), the largest quarterly jump ever, to a record 163 trillion yuan ($25 trillion), or 237% of GDP.
Up from 148% of GDP in 2007. But hard numbers are hard to come by in China. The Financial Times: “Despite increasing attention to the risk from China’s rising debt, there is surprisingly little consensus over basic facts such as how much China actually owes.”
The Bank for International Settlement pegged China’s total indebtedness at 249%. McKinsey, in a report last year that included debt owed by financial institutions, figured China’s total debt as of mid-2014 at 282% of GDP. Others are even gloomier. The FT:
Rodney Jones, principal of Beijing-based Wigram Capital Advisors, provides Asia macro analysis to billionaire investor George Soros, who last week likened China’s economy to the subprime-saddled US before 2008. Mr. Jones says Chinese banks use investments in wealth management products to disguise corporate loans as financial debt. Based on a detailed analysis of financial statements by more than 100 banks, he estimates China’s debt-to-GDP ratio at 280% at the end of 2015.
“The financial engineers have run amok again. They’ve run amok in the US and they’ve run amok here. That’s what George sees,” says Mr. Jones.
So there’s no reliable number on China’s total debt. There isn’t even a reliable number on China’s GDP. If China’s widely pooh-poohed official GDP numbers are inflated, then the actual ratio of total debt to GDP is even worse.
What sets off alarm bells isn’t the total debt per se but the speed with which it has soared. The proceeds from this sudden boost in lending are impossible to invest in productive assets or activities, particularly in an environment of devastating overcapacity after years of government-fostered debt-fueled malinvestment.
When returns on these new investments curdle, China’s non-performing loan fiasco – whose actual size also remains shrouded in mystery – will become even more gigantic.
“Every major country with a rapid increase in debt has experienced either a financial crisis or a prolonged slowdown in GDP growth,” warned Ha Jiming, Goldman Sachs chief investment strategist.
At the moment, short-term stimulus – however ineffective or destructive over the longer term – is what matters to Chinese authorities who’re desperately trying to keep their elaborate construct from falling apart. The consequences?
Projections range from a “Lehman moment” with banks toppling and credit markets seizing to “a chronic, Japan-style malaise in which growth slows for years or even decades.” The Financial Times:
Jonathan Anderson, principal at Emerging Advisors Group, belongs to the first camp. He warns that banks driving the huge credit expansion since 2008 rely increasingly on volatile short-term funding through sales of high-yielding wealth management products, rather than stable deposits. As Lehman and Bear Stearns proved in 2008, this kind of funding can quickly evaporate when defaults rise and nerves fray.
“At the current rate of expansion, it is only a matter of time before some banks find themselves unable to fund all their assets safely,” Mr. Anderson wrote last month. “And at that point, a financial crisis is likely.”
Others believe the People’s Bank of China will retain its ability to ward off crisis. By flooding the banking system with cash, the PBoC can ensure that banks remain liquid, even if non-performing loans rise sharply. The greater risk from excess debt, they argue, is the Japan scenario: a “lost decade” of slow growth and deflation.
Michael Pettis, professor at Peking University’s Guanghua School of Management, says rising debt inflicts “financial distress costs” on borrowers, which lead to reduced growth long before actual default.
“It is wrong to assume that ‘too much debt’ is bad only if it causes a crisis, and this is a typical assumption made by almost every economist,” Prof Pettis wrote in a draft of an forthcoming paper shared with the Financial Times.
“The most obvious example is Japan after 1990. It had too much debt, all of which was domestic, and as a consequence its growth collapsed.”
No wonder Chinese authorities are obscuring vital economic data. Reality is too ugly to behold. Even a glimpse of it might precipitate a “Lehman Moment” or decades of Japan-style stagnation, the very conditions they’re desperately trying stave off.
The move of Chinese money into real estate in the US, Canada, Australia, and New Zealand has become legendary. More recently, Chinese companies, supported by state-owned banks, have pushed into global M&A, buying companies lock, stock, and barrel. At the same time, the Chinese have been dumping US stocks and bonds. What gives? Read… Who the Heck Is Buying the US Stocks that Chinese and other Foreign Investors Are Massively Dumping?