How Should the World Prepare for a Slower China?

A ChinaFile Conversation

Get Ready for a Slower China

The recent gyrations on the Chinese interbank market underscore that the chief risk to global growth now comes from China. Make no mistake: credit policy will tighten substantially in the coming months, as the government tries to push loan growth from its current rate of 20% down to something much closer to the rate of nominal GDP growth, which is about half that. Moreover, in the last few months of the year the new government will likely start concrete action on some long-deferred structural reforms. These reforms will bolster China’s medium-term growth prospects, but the short-term impact will be tough for the economy and for markets.

The combination of tighter credit and structural reforms means that with the best of luck China could post GDP growth in 2014 of a bit over 6%, its weakest showing in 15 years and well below most current forecasts. A policy mistake such as excessive monetary tightening could easily push growth below the 6% mark. Banks and corporations appear finally to be getting the message that the new government, unlike its predecessor, will not support growth at some arbitrary level through investment stimulus. The dire performance of China’s stock markets in the past two weeks reflects this growing realization among domestic investors, although we suspect stocks have further to fall before weaker growth is fully discounted.

But the China risk is mainly of a negative growth shock, not financial Armageddon as some gloomier commentary suggests. Financial crisis risk remains relatively low because the system is closed and the usual triggers are unavailable. Emerging market financial crises usually erupt for one of two reasons: a sudden departure of foreign creditors or a drying-up of domestic funding sources for banks. China has little net exposure to foreign creditors and runs a large current account surplus, so there is no foreign trigger. And until now, banks have funded themselves mainly from deposits at a loan-to-deposit ratio (LDR) of under 80%, although the increased use of quasi-deposit wealth management products means the true LDR may be a bit higher, especially for smaller banks. The danger arises when banks push up their LDRs and increasingly fund themselves on the wholesale market. So a domestic funding trigger does not exist—yet.

The People’s Bank of China (PBC) clearly understands the systemic risk of letting banks run up lending based on fickle wholesale funding. This is why it put its foot down last week and refused to pump money into the straitened interbank market. Its message to banks is clear: lend within your means. This stance raises confidence that Beijing will not let the credit bubble get out of control. But it also raises the odds that both credit and economic growth will slow sharply in the coming 6-12 months.
If the economy slows and local stock markets continue to tumble, doesn’t this mean the renminbi will also weaken sharply? Not necessarily. Beijing has a long-term policy interest in increasing the international use of the RMB, which can only occur if the currency earns a reputation as a reliable store of value in good times and bad. Allowing a sharp devaluation now runs against this interest, and also would be a sharp break from a long-established policy of not resorting to devaluation to stimulate growth, even at moments of severe stress (as in 1997-98 and 2008-09). So while our call on China growth has been marked down, our call on the RMB has not.

From a broader perspective, the biggest China risk is not that the country suffers a year or two of sharply below-trend growth. If that slowdown reflects more rational credit allocation and the early, painful stages of productivity-enhancing reforms, it will be healthy medicine. And even a much slower China will still be growing faster than all developed markets and most emerging ones.

The real risk is rather that the new government will show a lack of nerve or muscle and fail to push through financial sector liberalization, deregulation of markets to favor private firms, and fiscal reforms to curtail local governments’ ability to prop up failing firms, overspend on infrastructure, and inflate property bubbles. The old government wasted the last three years of its term doing none of these things despite the obvious need. The new leaders are talking a better game, but they have a year at most to articulate a clear reform program, begin implementation (liberalizing interest rates and freeing electricity prices would be a good start), and ruthlessly removing senior officials who stand in the way. If they fail to deliver, then the short-term slowdown could become a long and dismal decline.


Arthur Kroeber and I have often been paired in bull vs. bear face-offs (one host called it a “cage match”), but despite this, I’ve also found that Arthur and I share similar diagnoses and similar concerns regarding China’s economy. We may reach different conclusions, but we speak the same language.

I agree with Arthur that the key to China’s economic future lies in much-needed (I would argue long overdue) market reforms. There are real productivity gains that can be realized, but to do so requires removing distortions that direct resources in the wrong direction, and greater openness that creates space for entrepreneurship and innovation outside the strictures of the Five Year Plan. These reforms will mean the Party giving up direct control over economic outcomes, a revolution that Premier Li Keqiang says—according to The Guardian's translation—will be “painful, like slitting our wrists.” They will take bold vision and a willingness to challenge deeply entrenched interests.

Perhaps the PBOC determination to rein in runaway credit expansion is an early sign that China’s new leaders are up to the challenge. But I fear that Thursday’s near-collapse of the critical interbank lending market offers just a taste of how wrenching and difficult it will be wean China’s economy away from its over-reliance on runaway credit to fuel growth and paper over losses. Given the rapid expansion of China’s “shadow” credit channels, and their murky interactions with the balance sheets of China’s formal banks, I’m not nearly as confident as Arthur is that Chinese regulators can rein things in without courting real financial instability. China’s economy is filled with savers who think they have quasi-deposits backed by the banks, but whose money is really tied up in Ponzi schemes with funds locked up in illiquid and possibly non-performing assets. Interrupting the circular flows of money that keep these schemes going is like trying to stand up in a canoe—theoretically possible, but hard not to end up falling overboard.

Even if Chinese officials can rescue every potential default, the result will be more and more resources devoted to propping up existing levels of economic activity, rather than driving growth. We’ve already seen this with the multi-million dollar bailouts in China’s solar sector, and with state-directed efforts to buy up excess property inventories and turn them into subsidized housing. Like in Japan in the 1990s, these efforts can prevent a collapse in GDP, but cannot sustain GDP growth. And the more bad debt is rolled over and repackaged in the banking and shadow banking systems, the less financing is available to keep China’s investment boom going, without blowing out the money supply. The result is a steady squeeze on growth.
The key is to create (or allow) market mechanisms that impose real accountability, penalizing waste and rewarding real wealth-creation. But accountability can be painful. We saw in Thursday’s money market meltdown what can happen when China’s rulers try to stop writing blank checks.