China’s Economy Under Mounting Stress

China’s Economy Under Mounting Stress

WAYNE ARNOLD

March 26, 2014 12:16 p.m. ET

HONG KONG—Bad news is piling up for China’s economy, raising fears Beijing’s financial power may not be sufficient this time around to keep the economic engine ticking over and stave off market instability.

Signs of economic stress are mounting as companies report disappointing profits and state-owned banks take large debt write-offs. On Wednesday, Bank of China601988.SH +0.39% reported its second-weakest profit growth since its initial public offering in 2006.

Standard & Poor’s, also on Wednesday, added to a chorus of concern over China’s debt. The ratings firm, in a quarterly Asia credit report, warned that policy makers may have to move sooner than expected to deal with massive lending by the so-called shadow banking sector, which encompasses local government financing vehicles, property developers and trust companies.

China has so far sidestepped large-scale defaults. Earlier this month, a solar-components maker became the first Chinese company to default on a domestic bond. But S&P cautioned that China soon may have to sanction wider defaults of risky wealth-management products issued by the nonbank sector.

Chinese authorities, with trillions of dollars in financial assets, are unlikely to allow a full-blown credit crisis, the ratings firm said. But S&P raised a fear that is gaining traction among China watchers: authorities may not be able to avoid some financial turmoil—and that will hit economic growth.

“Even viable investments could struggle to get financing,” S&P said. “China’s growth could fall sharply for at least a few quarters, led by investment.”

Countries that export heavily to China to feed its growth are worried any hiccups could impact their economies.

“You could see significant periods of turbulence in financial markets potentially affecting growth in China—and in commodity prices that would hurt Australia and New Zealand,” Grant Spencer, deputy governor of the Reserve Bank of New Zealand, said Wednesday.

China’s government is forecasting 7.5% growth this year, among the fastest rate of any major economy. Nev Power, chief executive of Fortescue Metals Group Ltd.FMG.AU -1.88% , an Australian miner, said Wednesday he believed urbanization will continue to drive strong Chinese demand for iron ore even if growth there moderates.

Still, China’s economic rebalancing away from credit-fueled investment in heavy industries like steel toward more domestic consumption has led to a fast deceleration in growth. This week, HSBC HSBA.LN -0.08% said the preliminary estimate of its closely watched barometer of China’s factory activity fell to its lowest in eight months. Industrial production in the first two months of 2014 cooled to the slowest growth in five years, according toCredit Suisse. CSGN.VX +0.55% And retail spending, investment and the housing market are showing signs of weakness.

Goldman Sachs GS -0.93% last week cut its forecast for China’s first quarter annualized growth in 2014 to 5% from 6.7%. The gloom is reflected in Chinese corporate earnings: The world’s largest cellular operator, China Mobile, 0941.HK +1.56% reported last week its first decline in profits in 14 years. The country’s third-largest bank, Agricultural Bank of China, 601288.SH -0.42% posted its weakest profit growth last year since selling shares to the public in 2010. The bank doubled its volume of write-offs and transfers of bad loans in 2013 compared with the previous year.

“They are going through a painful deleveraging and credit-tightening process due to the excessive debt borrowing to stimulate the economy after the global financial crisis,” said Tan Kong Yam, an economics professor at the Nanyang Technological University in Singapore.

As growth slows, the government has stepped in with some fiscal stimulus measures, as it did when expansion faltered in 2013. In recent days, Beijing has authorized $23 billion for five railway lines. The People’s Bank of China also has allowed the yuan to fall since February, helping exporters, and has eased liquidity in the domestic banking system.

But China’s ability to spend its way out of the problem is limited if it is serious about shutting down unprofitable state-owned industries and curbing unproductive investment, said Andrew Batson, research director at Gavekal Dragonomics, a Beijing-based economic-research firm.

Under pressure from Beijing, large state-owned firms are cutting back on spending. China Petroleum & Chemical Corp. 600028.SH -1.17% , which is known as Sinopec,the nation’s largest refining company, said last week it would reduce capital expenditures by 4% in 2014. China Telecom CHA +1.58% and PetroChina Co. 601857.SH -1.05% also announced cuts to investment plans.

A widening corruption crackdown has made government officials reluctant to spend their budgets, said Dong Tao, head of non-Japan Asia economics at Credit Suisse in Hong Kong.

The other option open to the government—easing monetary policy further—has its own downsides. Credit is still growing faster than the economy and by some estimates is twice the size of China’s gross domestic product.

Pushing more lending to unproductive state industries wouldn’t add much to growth, and would add to the risk of defaults, many economists say. “The real economy doesn’t need more credit,” said Mr. Tao at Credit Suisse. “We’re in a process of adding straws to the camel’s back.”