Lurching Between Hope and Despair; Is a Chinese Hard Landing Inevitable?

China is  still grappling with spreading financial imbalances and trepidations arising from its distortionary  overextended export-led industrial structure that could result in severe socio-political challenges. Back in the July last year, this forum predicted  the continuous weakness in China’s stock markets and interpreted it as a leading sign of the troubles ahead for the China's real economy. We wrote the Chinese stock market crash : 

is providing leading signals about the direction of China’s economy and its medium term outlook. (...) The Chinese economy is badly distorted by following a lopsided export-led-growth model for far too long.

 A week later China’s stock market dropped by another 8 per cent, and  by January 14^th  this year, Shanghai index had dropped more than 20 per cent from its December high, which led George Soros to argue:

"The Chinese left it too long to address the changeover in the growth model that they have to adopt from — investment and export-led to domestic-led. So a hard landing is practically unavoidable," 

Obviously concerned about the fragile state of the economy, Chinese President Xi Jinping in his recent keynote speech in the G20 summit in Hangzhou  stated:

China’s reform has entered the deep water zone where tough challenges must be met. We have the resolve to make painful self-adjustments and tackle problems that have built up over many years, particularly underlying issues and entrenched interests and carry reform through to the end. We will continue to carry out supply-side structural reform, resolve major problems in economic development and improve the performance of the supply system by optimizing factors allocation and adjusting industrial structure. With these efforts, we can energize the market and achieve coordinated development. We will continue to explore new institutional mechanism, break through the resistance of vested interests, exercise law-based governance and better leverage both the decisive role of the market in resource allocation and the role of the government.

China's outdated and inefficient export-led model is the main source of its overcapacity, which is devouring a massive amount of the newly generated credit without an adequate pay-off. In fact, the bulk of the country's investment is undertaken by the local governments that have been the main source of a sharp surge in credit growth,  endorsed by the central authorities. The government has impelled provinces to issue massive volumes of new bonds, apparently to replace the more costly bank debt but in actuality has generated a marked increase in the public investment. As a result over the past 24 months China's domestic credit has expanded more than the corresponding amount in 2008-9, which was created to stimulate growth after the global financial crisis. However due to the 'adverse selection' problem, the newly generated credit has lost three-fourth of its effectiveness in generating growth. Meaning, to generate one yuan of additional GDP it now takes nearly four yuan of new borrowing relative to a slightly higher than one yuan of credit that was required before the financial crisis. 

 Mr Xi has acknowledged that economic reform is "crucial to maintaining medium-high rate of growth under the new normal", and that "China will take sure and firm steps in advancing reform and will not slow down its pace". However, reforms have been painfully slow, more specifically with regard to China's most pressing challenges i.e., state-owned enterprises (SOEs) that are burdened with excess capacity, and  the alarming level of debts. China's central government manages 111 companies. In addition, around 25,000 SOEs are managed by the local governments. Since the 1990s, SOEs have been consolidated through closures and mergers but this downsizing came to a halt in 2007-2008 when the government rolled out a stimulus programme to cushion the effects of the global financial crisis and finance went into factory constructions and equipment without the demand to meet this supply. Many of these enterprises are restrained by a massive debt burden, as an  estimated 40 per cent of new debt is used to service the existing loans, and a large number of firms' debt services are more than their earnings before tax.

Despit the fact that the reform of SOE is of high priority for the Chinese government, there has been little progress in gaining efficiency, reducing overcapacity and utilizing technological advances in these entities. In September 2015, China released  the long-delayed guidelines for reforming these firms that included introducing "mixed ownership" by bringing in private investment.  The main aims of guidelines are to improve the prospects for domestic growth and enhance the export competitiveness of its largest firms known as yangqi, that are inflicted by low productivity, weak balance sheet, and serious corruption.  However, "decisive results" are expected by 2020!

In a futile attempt to resuscitate the export-led model, Mr. Xi acknowledging the fact that  in today's globalized economy "countries are closely linked in their development and they all rise and fall together," and stressing the point that  "no country could seek development on its own."  However, global  expansionary policies have become ineffective and cannot generate demand for China's export-oriented industries. Mr. Xi argued:

The world economy is now in profound adjustments and moving along a twisted path to recovery. It stands at a crucial juncture where new growth drivers are taking the place of old ones. The dynamism provided by the last round of scientific and industrial revolution is waning while new impetus for growth is still in the making. Currently, protectionism is rising; global trade and investment are sluggish; the multilateral trading regime faces bottlenecks in development, and the emergence of various regional trade arrangements have led to fragmentation of rules.

As we have argued in this forum before, the new impetus for growth, stemming from  smart materials, internet of things, cloud computing,  Big Data , Nanotechnology and so on is huge. However, what hampers the growth is financial imbalances and the associated uncertainty that restrict private capital formation.   Based on the recent data it appears that China’s economy has grown close to  6.7 per cent  in the first half of 2016, mainly due to a sharp increase in credit. In August, China's total fixed-asset investment  grew 8.1 per cent  from the year before,  a rebound from July’s 3.9 per cent. Yet, growth was concentrated in investment by the SOEs, which grew 21.4 per cent in the first eight months of the year, offsetting a decelerating growth in the private  investment to  2.1 percent, over the same period. Thanks to credit growth and an ensuing speculatively-driven housing boom together with increased fiscal spending of 12.7 per cent China's factory output and retail sales grew faster than expected in August. However reflecting an expected sharp decline in private-sector fixed-asset investment, continued deleveraging and fragile global demand; the prospects for the upcoming quarters are now getting gloomier.

 Of course, a more than likely severe slowdown of world’s second-largest economy will have global consequences. China with its  biggest banking sector in the world that boasts an asset base of equivalent to 40 per cent of global GDP, its second largest stock market  that worths $6 trillion  and its third largest bond market, at $7.5 trillion is massively contributing to the global growth, and its slowdown would sharply exacerbate  the already fragile growth in a financially imbalanced world.  More specifically, an estimated 0.2 percentage points of the global growth would be wiped out as a result of direct impacts of each  one-percentage-point decline in Chinese GDP growth rate.  The indirect impacts  from a decline in international trade,  slowing of global growth, and increased uncertainty could  be  as large as 0.4 percentage points.  Thus, a slowdown of Chinese economy by 3 percentage points, to say 3.7 per cent in the coming quarters, would shave about 1.2 percentage points from the currently tepid global growth, i.e. would generate a global recession, which would be particularly devastating for commodity exporters around the world.

Unfortunately in his speech,  president  Xi did not mention that China’s debt-to-GDP ratio that has surged from 150 per cent to more than 260 per cent over the past decade. This is stemming from an unsustainable credit growth aimed at achieving  unrealistic high export-led growth targets that are based on specious economic models.  According to a statement by China's State Council the country's three government-owned banks i.e., the China Development Bank, the Export-Import Bank of China and the Agricultural Development Bank of China are instructed to expand credit to investment projects. According to Bloomberg these banks have raised a combined 3.4 trillion yuan ($509 billion) through bond sales and low-rate credit from the People’s Bank of China, and according to Economist

In the past year alone, China has spent nearly $200 billion to prop up the stock market; $65 billion of bank loans have gone bad; financial frauds have cost investors at least $20 billion; and $600 billion of capital has left the country. 

China's  Annual GDP Growth Rate

Fixed Asset Investment Growth

China's Balance of Trade, $bn.

Clearly, the recent surge in credit growth and fiscal policy cannot be substituted for the normal market forces and soon the country will have to deal with the recessionary market impulses as the impacts of expansionary fiscal  policy vanish and as the authorities would inevitably refrain from credit expansionary policies due to their damaging "adverse selection" consequences, among them for instance  more than doubling of the non-performing loans   over the past two years which now stands at 5.5 per cent  of bank's total lending. China needs to tap into its enormous domestic consumption potentials through market forces. Chinese investments in export-led growth and its speculative investments in real estate market should be diverted into investments in health care, education and other personal services, utilities, transportation and communications. A robust domestically oriented sector would  provide supports for domestic manufacturing and related services. Perhaps the upcoming sharp deceleration would trigger a move toward this rebalancing of the economy.

World's 20 largest Economies -2015 E
Percentage share of total global nominal GDP in US$