With the United States economy still struggling to regain full employment, the European economy becalmed in the aftermath of a serious sovereign debt crisis and many emerging markets looking increasingly vulnerable, global macro-economic attention has become increasingly focused on China.
Will China’s economy slow down, and would such a development carry serious financial fallout, even some sort of crisis?
Some commentators have suggested that China could be facing a Lehman moment (or even a Greece or Spain moment) with some particularly Chinese characteristics. None of this sounds good, and some of it sounds downright scary. But much of the speculation also seems like a stretch, if not an exaggeration of the negative implications for both China and the global economy.
There is a serious issue in China. Starting 2009, to offset the potential effects of the global financial crisis, the government encouraged a huge credit boom. This credit was largely used to finance real estate construction and infrastructure, helping China grow 45 per cent from the end of 2008. The numbers are staggering. Over the same period, the International Monetary Fund reports total financial sector financing outstanding (credit of all kind) rose to nearly 200 percent of gross domestic product at the end of the first quarter of 2013, from 125 percent of GDP. That is a $13 trillion increase in bank loans, bonds and various non-bank financing. This sum is three-quarters of annual United States’ GDP.
The vast bulk of this increase, more than two-thirds of the total, was in non-bank financing — meaning credit that flowed through a financial institution other than a regulated bank. When credit booms end, there is often some kind of bust. The Lehman crisis in September 2008 was one of the worst busts you can get; the failure of Lehman made people fear that many other banks and corporations could fail, and there was a sudden rush of funds from money markets, investment banks and bank deposits to safe United States Treasuries.
Corporations were no longer able to roll over loans and their other sources of financing, such as commercial paper. As a result, the economy contracted rapidly and people were fired. Were it not for huge Federal Reserve interventions, the banking system could have crashed from a loss of liquidity, that is, lack of short-term funding.
China is not going to experience a Lehman sort of crisis, at least not now. The most serious problem in China is that non-bank “shadow” banking, especially trust securities and various types of bonds, grew rapidly with insufficient oversight. For the most part, this represented an attempt to circumvent the interest-rate controls that made bank deposits unattractive.
Savers moved funds from banks to buy these instruments. Now, just as was the case with sub-prime loans in the United States, some of these high-risk borrowers are failing to repay. Savers will lose some money on those investments, so now savers will be returning to banks, not fleeing from them.
The current battle is over who will bear the losses. During China’s last financial crisis in the late 1990s, the losses were on the banks’ balance sheets, and the government eventually bore the brunt by recapitalizing banks. Until recently, there was some degree of confidence that the government would bail out both banks and non-banks this time — in part because the regulated banks also sell some of the most dubious unregulated financial products. In the jargon of financial markets, the shadow banks were therefore, in part, a moral hazard trade, very much akin to what we saw in the United States and in Europe in the period leading up to 2008.
However, now the Chinese government is making it clear that the non-bank financing instruments will not be bailed out, while the big banks are still obviously supported by the government. Just as in America and Europe, China’s biggest banks will live for another day, but the shadow banking sector is set to shrink.
So instead of facing a Lehman crisis, China’s financial system is facing a more standard credit bust, driven by the drying-up of the non-bank markets and some losses on bank loans. The eventual solutions to such problems are well understood. Again to make a comparison, the Chinese strategy for dealing with the lurking problems of banks will be very similar to what we just saw in Europe and the United States: Let the banks slowly recognize their losses, and support the banks with credit from the central bank as needed.
While no one knows how large those bank losses are, China luckily has substantial scope for absorbing losses. For example, the Industrial and Commercial Bank of China, one of China’s largest banks, reported $59 billion of operating profit (before loan loss provisions) over the last 12 reporting months, according to data compiled by Bloomberg. It can use that profit to offset losses on its $1.5 trillion loan book (over and above the $38 billion that it has already provisioned).
Even if 10 per cent of loans were to eventually default, with 50 per cent recovery on those loans, the losses to equity capital could be offset with just two years of profits. Share issuance (already priced into equity markets) could raise further capital if needed.
This high profitability of Chinese banks makes them far more resilient than American and European banks. For example, Washington Mutual, which eventually was taken over by the Federal Deposit Insurance Corporation, reported roughly half the profitability of the Chinese banks in the boom years before it collapsed.
The other buffer in China is a very high national savings rate, running at nearly half of GDP. These savings ensure banks’ deposit base will keep growing, and banks will be flush with funds to lend. The labor force is still growing, and investment in equipment and capital will remain high. All these factors buttress growth.
However, do not misunderstand us. A slowdown in Chinese credit growth seems unavoidable, and true GDP growth could easily turn out far below the 7.5 per cent target of the Chinese authorities for many years. So if China avoids a Lehman crisis but does face a serious growth slowdown, how worried should Europe and the United States be for their own economic growth? The answer is, not much at all.
But here there is an element of a zero-sum game. Raw material exporters would be hurt — Vladimir Putin take note — but Europe and the United States would gain as the prices fall for commodities they import.
On net, the total effect of a China slowdown could be small for growth in the United States or Europe, but it would definitely be more negative for raw material exporters and countries that produce manufactured goods imported by China. The fears that the world may be facing another “Lehman crisis” emanating from China seem very far-fetched.