China’s investment and export intensive growth model has propelled it to the position of the second largest economy in the world. The global economic slowdown unleashed in the aftermath of the Lehman crisis drove the Chinese government to support economic activity via massive infrastructure spending. Repeated recourse to such spending financed by leverage has become a convenient way to meet GDP growth targets.
But the damaging side effect of this strategy is the growing shadow banking system, which is involved in lending to dubious projects. While a great show has been made of lowering debt and punishing bad companies, it does not address the root cause.
Given China’s current economic structure, higher growth and lower leverage cannot be achieved simultaneously. It is time to let go the GDP growth target as well as the leverage based growth model.
The Chinese economy is not just the second largest in the world. It also holds the distinction of being the only emerging market (EM) economy in the top six in the world, well ahead of India and Brazil which hold the seventh and ninth places respectively.
But the investment driven growth model that has helped it secure this position has created a huge pile of debt. According to Standard & Poor’s China’s corporate debt as of end 2015 was 171% of GDP. This debt has becoming threatening in its own right not just due to its sheer size but also due doubts about the solvency of the corporates which have incurred them.
China is in the first year of its 13th five-year plan (FYP) and has set itself a minimum growth target of 6.5% over the five years to 2020. If history is anything to go by, the country looks set to achieve the target. In the past, whenever anything threatened to derail economic growth, the government simply resorted to higher spending on infrastructure and forcing state owned companies to undertake more capital investments.
Time and again, these tactics have spurred credit growth and delivered the envisioned GDP growth targets. But for every infrastructure project or capital investment undertaken, there has been a corresponding rise in the stock of debt.
Old Habits Die Hard – How China Got Addicted To Leverage
In the aftermath of the Lehman crisis, China launched a CNY4 trillion of stimulus with infrastructure projects accounting for 72% of the spending. Local governments were tasked with raising funds to carry out the spending. To keep the debt off its balance sheet, the central government financed less than a third of the stimulus package. The IMF estimates that the combined 2009 and 2010 stimulus by China was nearly 6% of GDP, among the highest in the world.
The economy responded to the stimulus and GDP growth stayed above 9% during the tough years of 2008 and 2009 and rose above 10% in 2010. Once the precedent was set, Chinese policymakers easily slid into the habit of boosting up infrastructure spending to shore up growth. Stimulus has sometimes been implicit in the form of speedy approvals for railway and renovation projects or subsidies for investments by state owned entities.
Being themselves barred from borrowing in the market, local governments have relentlessly raised funds for infrastructure spending via local government financing vehicles (LGFVs). Although LGFVs are legally distinct entities from the government, they have always appeared to carry an implicit guarantee of solvency as they often receive subsidies from the budgets of their local governments.
According to IMF estimates, the combined fiscal deficit of the centre and state governments after including LGFV borrowing will be 10.1% in 2016 compared to the central government’s target of 3%.
Shadow Banking – The Side Effects Of Debt Fuelled Growth
One of the damaging side effects of China’s debt driven economic growth is the rise of the shadow banking system, which is involved in lending to dubious projects. The Chinese government is effectively to blame for the growth of the shadow banking as it kept regulation light during the early stages when shadow banks served the borrowing needs of LGFVs.
Moody’s estimates that the shadow banking sector accounted for 78% of China’s GDP as of end Q2-2016. Over the past two years the government has made a big show about lowering leverage and punishing bad companies. It allowed a one-time conversion of LGFV debt acquired till 2014 into municipal debt and made it clear that going forward there will be no implicit guarantee on LGFV debt. The government has also allowed more companies to default unlike in the past when it kept on bailing out indebted companies. This year, it is also employing debt for equity swaps to convert distressed debt of state owned entities into equity.
Wrong Medicine – Investment Driven Growth Model Has Reached Its Limits
But none of these measures addresses the problem of continuing debt accumulation or its underlying cause. China continues to apply what economists have called “stimulus by stealth” to keep growth close to the FYP targets. During 2016 fiscal stimulus has yet again been deployed towards construction projects and capital spending such as purchase of ships by state owned entities. Local governments have been allowed to issue bonds to fund their projects. It is then no surprise that top rating agencies Moody’s and S&P downgraded China’s sovereign credit rating outlook from stable to negative in March.
The investment intensive growth strategy served China very well in the past when manufacturing costs were lower and global demand was high. But economic realities have changed since the 2008 crisis. China’s ageing demographic is making it lose cost competitiveness and weak global growth is lowering the volume demand for its exports. Reform requires sacrifices in terms of temptation to stimulate. Given China’s current economic structure, higher growth and lower leverage cannot be achieved simultaneously. It is time to let go the GDP growth target as well as the leverage based growth model.
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