When China reported 3rd quarter DGP figures last week, it was no surprise to see a 3rd straight quarter of 6.7% annual growth, placing them comfortably in the government’s 6.5-7% target range. Though some may take comfort from the continued predictability and stability of Chinese economic growth, the reliance on ever increasing credit growth, government spending and property price increases is clearly unsustainable. We have commented on the impending crisis before, and the diagnosis hasn’t changed.
As the property bubble shows few signs of bursting and state owned companies continues to borrow from state owned banks, total debt (government and private combined) approaches 300% of GDP, a 10x expansion over the last decade. This excessive credit expansion is finally gaining attention even from some corners of the establishment: The Bank for International Settlements recently drew attention to the fact that the Chinese Credit Gap (calculated as the difference between the credit-to-GDP ratio and its long-run trend) has grown to 30.1, a level unprecedented in a large economy. And even more telling, an anonymous article in China Daily warns about impending doom if China doesn’t solve its addiction to debt. Speculation is that the author could be none other than President Xi Jinping himself.
The Chinese banking system has total assets of approaching $35 trillion, significantly larger than the size of the US banking system leading up to the financial crisis, and for an economy that is still only approximately 60% of the US.
But though the problem is acknowledged, consensus is still that this is manageable. Some argue that though credit has ballooned, leverage has not, as asset prices have appreciated. If the Chinese central bank can successfully put a floor under asset prices, as Western central banks have attempted for years, things may still turn out ok. A few government initiatives to curb lending and de-froth the property market should set the stage for a smooth landing. Monetary expansion has primarily been conducted through the state owned banks and it is hoped that a tightening of lending standards will be enough to cool the economy without crashing it. The property market is key: half of all loans are linked to property. The continued property price explosion, up to 25% this year in the major cities, has led several city administrations to introduce measures to curb further rises, such as minimum requirements for downpayment of up to 50%.
But China is beyond salvation, the damage is already done. Future prudence cannot redeem past indulgence. During the last decade, loans have been extended far in excess of what has been needed to generate the reported levels of GDP growth. The massive credit expansion has, as could be foreseen, led to bad loans building up on the books of the banking system. Estimates are that non-performing loans could make up as much as 22%. The correction needed to re-set the massive imbalances that have built up over years of state directed economic development is profound, much larger than anything happening in the US or European economies leading up to the financial crisis in 2008.
Ludwig von Mises told us that “there is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”
We are about to experience the final catastrophe. Timing is as always difficult to predict. There will be no ‘voluntary abandonment’ here: like elsewhere, the authorities will throw every perceivable stimulus measure at the economy to delay the inevitable. One difference is that where monetary policy took the lead in Japan, the US and Europe, a massive fiscal expansion has been going on for years in China. But there may still be room for more. So far, compared to the rest of the world, the People’s Bank of China has been cautious, but will have to engage in large scale quantitative easing in order to recapitalize the banking system. As for interest rates, the benchmark PBC rate has been steady @ 4.35% for a year, but inevitably will be cut.
The eventual Chinese collapse could be on a much larger scale than the global financial crisis of 2008. US bank losses added up to a mere $650 billion. Given the size of the Chinese banking system, approximately $35 trillion, losses are likely to be much bigger, and compared to the size of the economy, much more severe. The ramifications for the global economy are significant, but as China continues to blow up ever bigger bubbles, the hope may be that the ‘final and total catastrophe’ will be upon us soon. The longer the wait, the bigger the crash.