Curious Capitalist

No, China Is Not Having a Lehman Brothers Moment

There's little doubt that China is in the midst of a credit crunch, but don't expect a global meltdown — it may not be felt outside the nation's borders

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Jerome Favre / Bloomberg / Getty Images

In the midst of a major global stock-market correction following news earlier this week that the U.S. Federal Reserve will likely begin winding down its $85 billion-a-month asset-buying program later this year, investors are suddenly fretting about something else — a banking crisis in China. Yesterday, the Chinese interbank lending rate soared to an all-time high, as banks suddenly turned off the money spigots that had been gushing for the past several years.

Chinese banks have made about a $1 trillion a year in new lending over the past four years, as part of their effort to buoy growth following the 2008 financial crisis. That’s something that many China watchers like myself have been following closely — in October 2011, I commissioned Ken Miller to write this piece looking at whether the dysfunctional cycle of cheap state loans to developers was leading to a real estate bubble the likes of what we’ve already seen in the U.S.

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Now, it seems that the state has suddenly decided that there is indeed too much liquidity and a risk of too many nonperforming loans in the system, and banks (which are all state-controlled) have suddenly shut off the money spigots. The question now is whether China is in for a banking crisis, and what that might mean for the world.

There’s little doubt that credit in China is in the red zone, as Morgan Stanley head of emerging market Ruchir Sharma wrote in a very smart piece in the Wall Street Journal in February: “If private credit grows faster than the economy for three to five years, the increasing ratio of private credit to GDP usually signals financial distress. In China, private credit has been growing much faster than the economy since 2008, and the ratio of private credit to GDP has risen by 50 percentage points to 180%, an increase similar to what the U.S. and Japan witnessed before their most recent financial woes.”

Sounds worrisome. Yet a key thing to remember is that the Chinese banking system is very much ring-fenced from the rest of the world — offshore investors and foreign banks have hardly any access at all to domestic capital, bond or loan markets (the Chinese don’t borrow overseas and foreign banks control about 2% of capital in the country). A few days ago in Shanghai, I met with Andy Rothman, a respected analyst at CLSA bank. In a May 2012 report called Misunderstanding China, Rothman made a persuasive case about why too much lending in China might well slow the economy, but probably won’t cause a Lehman Brothers–style meltdown that would infect the rest of the world. “China’s financial system is an empire set apart from the world,” he writes. “While the party no longer micromanages financial institutions on a day-to-day basis, it continues to control the personnel process, including at banks where the majority of shareholders come from the private sector. And party control of the financial system extends well beyond the banks. In China’s stock markets, the party controls the IPO process and the majority of the listed companies.”

That doesn’t mean that China’s financial system is safe — it simply means that the global fallout is limited, and the risks are different from what they might be in the U.S. “Party policymaking,” writes Rothman, “is the biggest near-term risk in China’s financial system. A systemic crash is extremely unlikely, as the party is probably the world’s most liquid financial institution, but the high level of control leads — as it does in any bureaucracy — to high-frequency interference or intervention. And the more likely bureaucrats are to intervene, the higher the risk of mistakes and policy decisions that deliver significant, short-term, unexpected negative consequences.”

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The Chinese themselves have always known that the amount of new lending over the past few years would lead to a rise in nonperforming loans in the economy — indeed, I was in China a few years ago when the lending started and the head of one of the largest state-owned banks, ICBC, told me as much. Indeed, some experts estimate that 20% to 30% of loans in the Chinese banking system may go belly up. Yet optimists would note that China’s more than $3 trillion worth of foreign exchange reserves would cover even a meltdown of that size. And some experts say a major raft of bad loans might force the government to consider doing things like creating a local bond market, which would allow provisional governments, currently dependent solely on land sales for revenue (only Beijing has the power to tax) to find other ways of raising money. Certainly financial liberalization of this sort was something that people like Hank Paulson were pushing for at TIME’s sister publication Fortune’s recent Global Forum in Chengdu, China.

What’s very clear is that China is slowing. The number (which I’ve heard put at anything from 4% to 8% GDP growth per year) is less important than the fact that China has entered a new, permanent period of slower growth, one in which double-digit GDP growth is a thing of the past. It’s not a poor country anymore, it’s a middle-income country — and that brings growth challenges that are traditionally much harder to overcome than those of poorer nations. “The risk now [from a financial crisis] is stagnation, not blow up,” says Andrew Batson, the head of research for GK Dragonomics, a Beijing-based economics publication, with whom I recently met during my trip to China. “The new leadership gets this. They know they kept going with credit too long after 2008, and I think they are now going to start doing some real supply-side reform.” There’s plenty to do, and indeed, the government has made some important announcements recently about spurring private-sector growth, including discussing a path for reforming China’s hukou system, which restricts the income, legal rights and spending power of 250 million migrant workers, as I wrote in a blog post earlier this week.

Let’s hope the new government moves quickly to reform China’s dysfunctional economic model and boost private consumption. The Middle Kingdom may not have a Lehman-style meltdown, but it’s one of the three key legs on the stool that is the global economy, along with the U.S. and Europe, and it represents 27% of global growth. Even without a full-blown financial crisis, if China starts to slow down, we’ll all feel the headwind.