China admits its ills but faces an unpalatable cure

March 17, 2014 6:13 pm

China admits its ills but faces an unpalatable cure

By Minxin Pei

Beijing can either prop up ailing borrowers or allow them to fail, writes Minxin Pei

Finally, Chinese leaders have admitted what the market has been saying for some time: defaults by Chinese borrowers are all but inevitable, possibly on a significant scale. Responding to questions at a news conference last week, Li Keqiang, the Chinese premier, admitted that “isolated cases of default will be unavoidable”.

Few are likely to share Mr Li’s optimistic view that only “isolated cases of default” will occur. Still, by speaking publicly of the possibility that investors will suffer losses on credit products, he indicated that Beijing may be ready to face the consequences of its decision to prop up growth with credit-fuelled investment. In the past five years credit has grown at an average of 20 per cent a year, more than double the average rate of economic growth over the same period. An astonishing $14tn of new credit has been extended since 2008. Much of this has been spent on building fixed assets such as infrastructure, real estate and factories.

Unfortunately a large portion of this investment – it is impossible to say how much – has been squandered on speculative property ventures, useless infrastructure and excess manufacturing capacity. To make matters worse, inadequate financial regulation has allowed borrowers of doubtful standing to gorge on a seemingly endless flow of loans.

As China’s macroeconomic environment deteriorates, a vicious cycle has taken hold. Slowing growth prolongs the country’s overcapacity problem, depresses prices of goods (such as coal and steel) that have attracted large speculative investments, and destroys the profitability of projects built on rosy assumptions of continuing high growth. The day of reckoning has now arrived. Beijing has two options, both of them unpalatable. It can either admit the obvious and start deleveraging, reducing the rate of credit issuance and allowing borrowers to default when they cannot meet their obligations. Or it can continue to prop up zombie borrowers with more credit.

Should it opt for the latter, a deceptive calm may last for a year or two. But when the inevitable crisis arrives it will be disastrous. According to estimates by Fitch Ratings, at the current rate of credit growth, China’s ratio of debt to gross domestic product will exceed 270 per cent by 2017. Interest payments alone will reach 20 per cent of GDP in that year.

Mr Li’s remarks last week suggest that Beijing may have decided to accept some intense pain now to forestall a future calamity. If so, we should applaud the Chinese leaders’ courage. Nevertheless, Mr Li and his colleagues will encounter serious difficulties in restructuring China’s debt-laden economy. Four challenges stand out.

First, Beijing’s newfound reluctance to offer bailouts indiscriminately may have the unintended effect of undermining confidence in the solvency of a wide range of borrowers. This could prompt a credit squeeze that produces more default than is desired.

The withdrawal of the government’s implicit guarantee will make lenders less willing to extend new credit or to renew old loans. This will almost certainly force a large number of borrowers into default – including some with viable plans that would eventually have enabled them to repay their debts. Even relatively healthy borrowers are likely to suffer.

Second, many Chinese debt contracts are guaranteed by third parties. If one borrower is unable to make good on its promises, the event could trigger a series of further failures, as entities that have stood behind the defaulting borrower are themselves unable to fulfil their obligations. Systemic risks could be far bigger than the Chinese authorities assume, and may reside in unexpected corners of the financial system. The ensuing shocks could cause severe damage to the real economy.

Third, the task of determining which borrower should go bust is unavoidably political. At present China lacks market-based institutions and procedures for bankruptcy, restructuring and liquidation. Government officials will be deciding which borrowers should be bailed out, and which should be allowed to go under. It is easy to imagine a politically driven process resulting in the survival of the best-connected borrowers rather than the fittest.

Finally, imposing financial discipline on the Chinese economy through default and credit retrenchment will make it harder to meet Beijing’s growth target of 7.5 per cent for 2014. To strengthen the credibility of their commitment to reform, Chinese leaders need to consider abandoning this artificial objective so that they will have more freedom to implement painful financial restructuring.

Mr Li’s candour on loan defaults is only a small step in the right direction. Beijing needs to show more resolve to restore stability in the financial sector.

The writer is a professor of government at Claremont McKenna College