China can outgrow overcapacity, at least for now
China watchers are worried that excessive lending leads to massive overcapacity. However, the risk of Beijing pressing too hard on the brake is even greater. At least for now, China should be able to growing its way out of its bad debt problems.
Banking regulator Liu Mingkang recently told a conference that China’s banks should lend out 6-7 trillion yuan next year, equivalent to about one fifth of China’s annual output. Some think that is too much. However, these fears are overdone. Indeed, if new lending falls below 10 trillion yuan, bad debts will soar, private investment will be crowded out and the economic recovery may be derailed.
Since the stock of loans has been enlarged by this year’s explosive credit growth, the regulator’s target represents a 15 percent increase in China’s loan base. This is in line with past trends, but marks a sharp slowdown from this year’s 30 percent growth in total loans.
Just to keep funding current ongoing projects, the economy would need 8.3 trillion yuan in new loans in 2010, according to Nomura estimates. So the current goal implies that here would be no money left for new projects, and some current projects will not receive funding.
Setting the credit growth target too low will make it hard for new borrowers, because banks naturally want to keep funding current projects. That puts private sector borrowers, who are expected to invest more next year following strong government investment this year, at a disadvantage.
What’s more, if the banks sense the government might tighten lending targets next year, they are likely to lend as much as possible at the start of the year. This will increase the volatility of credit.
At least for now, the costs of slower growth outweigh the risks that a rapid expansion in lending leads to a misallocation of resources.
In the past, China has built things first, then waited for demand to catch up. China’s eight percent plus annual growth has managed to absorb most of overcapacity so far. It will continue to do so in the near future.
China’s biggest advantage is that it has the world’s largest potential market, though its gross domestic product per head is less than that of Algeria. The country’s urbanization and industrialization levels are way below those of the developed countries. Since there is still a lot of room for growth, what looks like a waste today might even become sound investment in the future.
For example, Chinese automobile industry had more than 30 percent of overcapacity at the start of the year. But this year, total vehicle sales surged 38 percent after tax cuts and government rebates. Similarly, housing inventory looked bloated at the end of last year, but with total sales up 79 percent this year, inventory levels have dropped to the lowest level in recent years and the shortage has driven prices higher this year.
Why would the growth-oriented Chinese government set such a modest goal for credit growth? One possibility is that it is deliberately underestimating growth, knowing that the real number will be much larger. This year, Premier Wen Jiabao set a goal for 5 trillion yuan in new loans, but banks will have lent out 10 trillion yuan.
Of course there is a risk of over-stimulating. China might be quite effective in propping up the economy but has been less good at reigning it in.
When China started a wave of economic reforms, fixed asset investment jumped by 44 percent in 1992 and 62 percent in 1993. Then inflation surged to 22 percent, and the yuan depreciated by more than 80percent against the dollar as the money supply got out of control.
China then took some of the harshest measures seen in the past 20 years, cutting loans to ongoing and new projects. It even forced some projects to stop altogether. The tightening left thousand of projects incomplete, causing massive non-performing loans that lasted into the late 1990s. Even with such aggressive tightening, growth in broad money supply did not fall below 20 percent until four years later.
Nevertheless, circumstances have changed so the risk of over-stimulating is less than before. Ten years ago China had shortages in almost every product. This time, inflation is less of a concern. Far from being overvalued, the yuan looks undervalued. So money supply growth will make it less so. Higher consumption will also be a welcome shift in China’s traditionally export-oriented economy.
Just like a young man with a high metabolism, China at this stage should be able to gobble up the extra credit without digestion problems. As the economy matures, over-investment will become a problem. But it would be a mistake to exaggerate the risk at this point.