We’ve all by now learned about the dangers of too much debt. The U.S. is paying the price for an explosion of consumer debt. Europe is struggling with too much sovereign debt. Now one of the big questions facing China is whether or not Beijing’s policymakers are about to get their own lesson in the perils of debt-driven growth.
There is a debate raging among China watchers over the potential consequences of last year’s epic credit boom. Banks in China granted almost twice the number of loans in 2009 as they did the year before, an amount equivalent to nearly 30% of GDP. Any such expansion of credit has a powerful impact on growth. So what would happen to the Chinese economy if the credit spigot got turned off?
That’s exactly what’s happening. Chinese policymakers have raised the amount of money banks have to keep in reserve and introduced other steps to rein in lending, and the policies are working. In June, the amount of new yuan loans was less than 40% the total of June 2009. That’s a significant drop. And as a result, the economy is slowing down. How slow will China go? Well, that depends on your view of how important debt has been to China’s recent growth.
Yasheng Huang, an economist at the MIT Sloan School of Management, recently made the argument in The Wall Street Journal that the recipe behind China’s recent recession-busting performance is little more than the application of tons of credit, a method that has been tried before with dire consequences. Huang says that those analysts who believe China’s economic model – known as the “Beijing Consensus” or more generically “state capitalism” – is the secret to China’s success are therefore misguided:
Many Western analysts credited China’s 8.7% GDP growth in 2009 to the magical power of the Beijing Consensus. The explanation is actually far simpler: a massive accrual of debt…This is not an accident. Years of wage suppression—now fueling labor unrest—have emaciated domestic consumption as a growth driver, leaving the government with no choice but to resort to debt-financed investments to counteract the recession in the West. This raises a key weakness of the Beijing Consensus: the sustainability of GDP growth in light of changing credit conditions. The question is not whether China can keep growing when capital is abnormally cheap—any country could—but whether it will continue to grow when monetary conditions normalize.
Huang is less than optimistic that China can keep its growth rates up as credit growth slows:
In the short- to medium-term, China’s economic prospects will be determined by how well it manages to stimulate personal income growth while weaning the country off its debt addiction, without a hard landing that would surely come with a bursting of the housing bubble. Authorities are trying to do that now by allowing labor strikes for higher wages and putting some curbs on housing markets. That’s a good start, but the transition is also fraught with risks, such as political instability and an erosion of competitiveness.
Beyond the immediate impact, some economists are fretting about the risks the giant lending boom has placed on the banking system, and what impact that could have on growth down the road. Victor Shih, a political scientist at Northwestern University, has raised eyebrows by arguing a big part of China’s growth was due to a build-up of debt within the government, especially in the form of borrowing by special investment units of local governments. As a result, Shih says that China’s government debt to GDP ratio is much higher than official estimates, perhaps 70%, and if the problem isn’t properly address, it could go to 100% by 2012. That’s entering the same territory as Europe’s PIIGS. Here’s what Shih wrote a few months back in the Journal:
China seemingly has accomplished a miracle. Growth registered at almost 9% last year, yet the government debt-to-GDP ratio still stood around a modest 20% as of December 31. Has China enjoyed the proverbial free lunch? Far from it: The Chinese government has financed much of an enormous stimulus package through thousands of investment entities created by local governments. If Beijing doesn’t soon recognize this problem and put a stop to it, banks in China, which have provided the bulk of the funding, may soon face delinquent loans that rival even China’s enormous fiscal and foreign-exchange capacity.
Of course, not everyone agrees with these assessments. Arthur Kroeber, managing director of research firm GaveKal Dragonomics recently countered Shih’s position in the Journal, arguing that local debt isn’t spiraling out of control, that the level of debt is manageable and the borrowing was commercial and put to good use. Here’s Kroeber:
Critics suggest China risks financial collapse because this build-up of local debt, collateralized by inflated land values, has been used to finance wasteful infrastructure projects. The critics are dead wrong. China has a manageable local government debt problem, which it has already started to address. And the country’s overall debt burden is far more sustainable—and finances far more economically productive projects—than the debt burdens of many rich nations.
Even more fundamentally, not everyone sees China’s gravity-defying economic performance as primarily a result of a debt explosion. Here’s Goldman Sachs economist Michael Buchanan:
We remain very positive on the overall China outlook beyond the near term. In particular, we still completely disagree with the vocal but small minority that see China as a “credit driven investment bubble” – China has run aggressively counter-cyclical policy before the global credit crisis and so had room for the substantial easing…without seeing excess credit growth rise to the levels of other major countries.
So, what can we make of all of these arguments and counterarguments? My position has been, and remains, that any massive explosion of bank loans in the middle of a downturn is inherently dangerous. It is impossible that all of that cash got utilized efficiently and inevitably some borrowers won’t be able to service their debt, leading to an increase of bad loans at Chinese banks. We’ll have to wait to see how bad it gets, but clearly Beijing’s policymakers saw enough was enough and have held the banks back. And that will lead to slower growth. The combination of reduced credit and a global recovery looking more and more tepid, thus dampening demand for Chinese exports, will place more pressure on China’s growth rates.
More importantly, the way in which China has used debt to drive growth, as Huang points out, pours more cold water on the whole idea that China has invented some super-charged economic model that is superior to those of the West. Seems that China, in fact, is just repeating the mistakes made in New York, Athens and Madrid. Debt-driven economic expansions look nice for a while. But then tend to end ugly.