Former Economics Editor of the NZ Herald

Brian Fallow: China's debt a recipe for risk

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Is China about to be the epicentre of Global Financial Crisis II, the sequel? Illustration / Anna Crichton
Is China about to be the epicentre of Global Financial Crisis II, the sequel? Illustration / Anna Crichton

A warning light for potential financial stress is flashing in China, according to the Bank for International Settlements.

So is China about to be the epicentre of Global Financial Crisis II, the sequel?

Fred Neumann, HSBC's co-head of Asian economic research, thinks not.

Last weekend the Basel-based BIS pointed at how stretched China now is by a measure which has - elsewhere and in the past - proven to be a telling early indicator of stress in a country's financial system.

It is the credit-to-GDP gap, which looks at credit (to private sector non-financial borrowers) relative to gross domestic product and compares that ratio to its long-run trend for the country concerned.

In China this year the ratio has hit 210 per cent, when its long-run trend is 180 per cent.

The gap of 30 percentage points is really stretched - three times more so than what is normally a sign of impending financial stress. It has been climbing for five years.

New Zealand's credit-to-GDP ratio is 176 per cent, which is 14.5 percentage points below our long-run rate. It is one reason why some commentators believe financial stability concerns about the current housing boom are overblown - at least so long as interest rates remain low.

In Chinas' case, said HSBC's Neumann, speaking to the Herald during a visit to Auckland this week: "for the time being I would say there is no risk of imminent financial stress. [But] just because China doesn't go into financial crisis doesn't mean it doesn't have a structural growth problem."

China, he reminds us, has excess savings. It runs a current account surplus, at present around 2.5 per cent of GDP. That means that even though its economy is top-heavy in investment spending and light on consumption, its savings exceed what is necessary to fund that investment.

"China traps these excess savings behind capital controls and the Chinese government owns most of the large financial institutions which distribute the savings. Generally, if you have those three pillars of strength it is very hard to have an outright financial crisis."

But that does not mean the trend is sustainable, Neumann says.

"The Chinese government is wedded to its 6.5 per cent growth target, which is probably above the sustainable growth rate without pump priming. So long as that growth target remains in place, and supposedly it remains in place until 2020, China will continue to ratchet up its debt-to-GDP ratio and that is not a sustainable trajectory."

It is widely accepted, not least by the Chinese government, that the country's economy needs to rebalance.

If you really want to rebalance the economy, you not only need to encourage people to save less but also boost the incomes of households and that is challenging.

From the model which has propelled its extraordinary growth, it now has to shift to one with less investment and more consumption, less reliance on exports and more on domestic demand, more focus on services and less on manufacturing and construction.

When the current leadership came to power, there was a lot of encouraging rhetoric about the need for markets to play a decisive role in the allocation of resources and about structural reform of state-owned enterprises.

"They haven't really delivered," is Neumann's verdict.

SOE debt, for example, is much larger than private corporate debt, household debt or government debt and has been growing fastest.

Over the past year, private sector investment in fixed assets has plunged, to be little more than 2 per cent higher, year on year. That displays a caution on the part of businesses which Neumann attributes to uncertainty about the commitment to policy reform.

"If anything, in the past 18 months we have seen a strong rebound in investment in both infrastructure and housing construction. That means more investment, not less. The economy is still wedded to this."

Chinese households, meanwhile, continue to save more than a third of their income, though the ratio is declining, and household incomes, as a share of national income, are fairly low.

How China fares is important not just for us, but for the broader region.

"If you really want to rebalance the economy, you not only need to encourage people to save less but also boost the incomes of households and that is challenging because it would eat into corporate profit margins ... and potentially means wider public sector deficits," he says.

The International Monetary Fund, in its annual report on China last month, stressed "the need for decisive action to tackle rising vulnerabilities, reduce the reliance on credit-financed state-led investment and improve governance, risk pricing and resource allocation in the state-owned enterprise and financial sectors."

The IMF encouraged the Chinese authorities to tighten budget constraints on SOEs and liquidate or restructure those which are over-indebted, sharing the losses among relevant parties, including the government.

It welcomed the authorities' declared willingness to use fiscal policy if growth were to fall sharply in the near term, recommending among other things more spending on pensions, health and education as well as targeted social assistance for displaced workers.

China is New Zealand's largest trading partner, taking 18.5 per cent of this country's goods exports in the year to July and providing 20 per cent of imports.

How China fares is important not just for us, but for the broader region.

As China's growth rate slows and as the composition of that growth shifts more towards services, its relative contribution to the region's growth will decline. But it will remain very high.

The headwinds from a slowing China, which commodity-exporting countries have felt over the past couple of years, have now spread to countries like Japan, Korea and Germany which export machinery to the workshop of the world.

Export growth from Asia's emerging market economies has stalled over the past year or two.

And several of the region's economies have higher debt-to-GDP ratios than China, including Australia.

"Everywhere in Asia, including Australia and New Zealand, we are setting ourselves up for quite a bit of risk should inflation and interest rates rise again," Neumann says.

"But that is a few years down the line."

- NZ Herald

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Former Economics Editor of the NZ Herald

Brian Fallow is a former economics editor for the New Zealand Herald. A Southlander happily transplanted to Wellington, he has been a journalist since 1984 and has covered the economy and related areas of public policy for the Herald since 1995. Why the economy? Because it is where we all live and because the forces at work in it can really mess up people's lives if we are not careful.

Read more by Brian Fallow

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