Giant on the move
China’s pursuit of stability risks greater stress
By Ethan Devine
The author is a guest Breaking Views columnist; the opinions expressed are his own.
While Western economies wither, China is in an entirely different predicament. Beset by high inflation and a frothy real estate market, Chinese policymakers have been trying to cool their economy for going on two years. The central bank, the People’s Bank of China, has led the charge, restricting loans to real estate and hiking the required reserve ratio 12 times in 21 months.
Thanks to this, along with slower growth in the United States and Europe, Chinese inflation is now waning. Add an incipient export slowdown, and China may soon be able to loosen credit to everything but real estate. Neither too hot nor too cold, this Goldilocks economy superficially looks just right for China.
Unfortunately, the reality is that China’s economy more closely resembles a boiling bowl of porridge with a clump of ice in the middle. Poorer provinces are on a debt-fueled construction binge in open defiance of Beijing, so policymakers have to over-tighten where they do have control.
Private real estate developers are unsurprisingly feeling the squeeze, some borrowing at interest rates of more than 30 percent in the black market. Meanwhile, the rest of the private sector is suffering collateral damage. Credit has always been scarce for private companies in China, but now it is practically non-existent. Among the consequences, factory machinery orders are evaporating, and accounts receivable are ballooning as customers take longer to pay their bills.
Since stability remains China’s primary policy objective, some expect policy to ease, particularly with exports poised to slow. Recent riots in Guangdong, the heart of China’s manufacturing industry, are a reminder that a sharp economic downturn could be every bit as destabilizing as high inflation. But much of the Chinese economy is running too hot for wholesale easing.
Construction starts, for example, hit a new all-time high in July. This is particularly alarming since property sales are slowing. Credit-fueled construction may partly explain why China’s debt is growing so much faster than GDP. Fitch calculates that China’s total credit to GDP will end 2011 at 185 percent, up from 124 percent at the end of 2007.
An optimist might say the continuing boom in poorer provinces is consistent with official policy to spread prosperity inland. But it may be too much of a good thing. Nearly half of all construction spending in the last year went to provinces that collectively generate less than a quarter of China’s non-construction GDP and, in many instances, construction accounts for the vast majority of local economic activity.
China’s provincial construction mania has gone beyond anecdotal excess and the odd ghost city. And once addicted to construction growth, even scrupulous provincial officials must approve questionable projects to keep growing. The unscrupulous, meanwhile, profit from ignoring the absurdity around them.
The so-called shadow banking system accounts for a great deal of the excess. First, there are the trusts that live off bank balance sheets and lend primarily to real estate. The PBOC is trying to regulate these. Then there are manufacturers, metals traders, and other non-financial companies that tap lines of credit and lend the funds to desperate developers at fat margins. But the most dubious lending comes from nominally independent provincial banks flouting the PBOC’s directives.
The question is whether Chinese policymakers can deflate the bubble before it gets much larger — and in a way that makes China less bubble-prone in the future. As the United States discovered when the gilt came off its own Goldilocks economy in 2001, throwing more debt at the problem buys temporary relief at greater ultimate cost. The Chinese do not intend to repeat this mistake, but if they are not careful, they may have no choice: a soft landing could turn hard and demand a hasty return to stimulus.
Western market economies have hardly covered themselves in glory recently, but there are also limits to China’s central controls. The main problem is the fixed exchange rate, which creates far too many renminbi per dollar (and euro, and yen) and makes it hard for China to set its own interest rates, since high rates would attract more inflows. This leaves reserve ratios as the PBOC’s main policy tool, but rationing the amount rather than changing the price of credit means money gets funneled to those with connections.
Deflating real estate is eminently sensible, but doing so in the context of an undervalued renminbi only treats the symptom and would leave China vulnerable to the next asset bubble before it can grow out of the debt from this one. Floating the renminbi would treat the underlying problem, stemming the flow of liquidity that makes China so bubble-prone while subduing inflation, allowing the PBOC to liberalize interest rates, and enriching domestic savers. Of course, this does not mean policymakers will do it.
Just as the United States treated a debt overhang with more debt, China will probably treat a breakdown in its control economy with more controls. Perhaps the firing squad will combat moral hazard better than bankrupting Lehman, but history suggests that as long as there is too much money sloshing around, there will be someone willing to lap it up. In the end, freeing the renminbi is the only cure.