Time to Worry about China?

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I’ve gotten a bit of a reputation around the TIME office in Hong Kong of being something of a China basher. I don’t think that’s fair, since I have absolutely no doubt China will be the next great superpower. But I do have an issue with what I consider blind optimism on the part of many observers about the China growth story. Too many economists out here seem to wish away some of the serious structural problems in China’s economy. The prevailing attitude is that China is somehow more capable of dealing with such problems than other countries. I’m not convinced. There is every reason to be optimistic about China’s long-term prospects, but that doesn’t mean there won’t be bumps and bruises (and an occasional broken bone or minor coronary) along the road to global greatness. The U.S. had its share of crashes, panics, recessions, and even a civil war on the way to becoming the world’s indispensible economy. Why would China be any different?

I’m starting to wonder if China is heading into one of those rough patches right now. Sure, China’s GDP growth in 2009 (at 8.7%) was an amazing achievement. But now Beijing has to contend with the fallout from the measures it took to create that growth during the Great Recession.

For example, there is a fascinating story in The Wall Street Journal about the percolating problem of debt at China’s local governments. Provinces and cities gorged on bank loans during the downturn last year to spend on infrastructure projects, which was a major spur to GDP growth. But now, the Journal says, Beijing’s leaders have become nervous that local governments won’t be able to pay back their debts.

This problem gets at a much bigger issue: What damage has China’s stimulus plan done to its financial system? China’s GDP surge was created by a credit boom of biblical proportions. Banks granted almost twice the number of loans in 2009 as they did the year before, an amount equivalent to nearly 30% of GDP. This increase in credit runs counter to usual economic logic. In a downturn, banks should become more cautious, and there is less demand for loans anyway as corporations scale back investments. But China’s banks headed in the opposite direction. Could all of this deluge of loans have gone to creditworthy borrowers, to be spent on profitable projects that would allow them to pay their bankers back? Unless Chinese bankers have some superhuman powers to analyze credit risk (and I assure you they don’t), that seems impossible. If China’s local governments might be in trouble with their debt, what does that imply about state companies and the private sector? The question is not whether non-performing loans (NPLs) at China’s banks will rise. The question is by how much, and how destabilizing could that be?

I’m not the only one worried about this emerging problem. HSBC, in a Feb. 19 report, remarked that “the consensus among U.S. fund managers has become deeply bearish on China.” Among their chief concerns was the potential for rising NPLs (along with asset bubbles and inflation, other issues I’ll be following on Curious Capitalist). Garry Evans, HSBC’s global head of equity strategy and the report’s author, acknowledged that higher NPLs are a possibility, but then seems to consider it an issue for the future, not the present. Even if some of the loans turn to NPLs, he comments, the process in many cases could take five to 10 years to play out. “A rise in NPLs will not be an issue for this year or next year,” Evans wrote.

Many economists out here will tell you there is a good likelihood China will face rising NPLs, but they don’t see that as a significant danger, at least not right now. Hopefully, they’re right. But China’s regulators are obviously worried, and I assume they know more about the extent of the problem than we do. For the past two months, China’s leaders have been taking steps to rein in the banks’ lending and the risk mounting on their balance sheets. Just last weekend, China’s bank regulator announced new directives aimed at improving credit quality and preventing the misuse of loans by borrowers.

By now any American can tell you about the horrors of excessive, risky debt. Let’s hope China is not making the same mistake.