China’s sugar rush may be ending

May 17, 2011

James Saft is a Reuters columnist. The opinions expressed are his own.

There are signs that China’s stupendous debt-fueled boom is cooling, posing new risks for global growth and markets.

The People’s Bank of China on Thursday raised the bank reserve requirement ratio to a record 21 percent, a rise of a half a percentage point and the fifth so far this year. The move, effectively a tightening of monetary policy, comes as inflation at 5.3 percent remains high and industrial output slides, albeit to a still high 13.4 percent in the year to April.

China is an economy addicted to investment, a sort of fun house mirror of the U.S.’s addiction to consumption, with an astounding 93 percent of GDP growth in 2009 attributable to investment.

That’s a strategy that worked well for years, but China’s response to the global financial crisis, a sort of all-in push for lending and investment, has led to over-heating, uneconomic projects and possibly now a disruptive slowing of growth.

An estimate by Lombard Street Research of broad money growth, including various banking shenanigans, showed growth equal to 40 percent of GDP in 2010, but falling quickly to 23 percent of GDP in the first quarter. Those figures reflect the tremendous growth of money being pushed through the banking system and through a shadow banking system that grew rapidly last year as banks tried to evade government control. The slowdown is almost as striking as the still heady heights of the growth.

That money powered investment across China into infrastructure, industrial production and real estate, sucking as it did tremendous amounts of raw materials and industrial goods from elsewhere in the world.

If Chinese appetite cools, the effects elsewhere will be large, both in countries like Germany which supply goods and places like Australia which supply materials.

There are complex opposing forces in China, with the central bank applying the brakes but other government authorities deeply ambivalent about the implications of a slowdown in investment.

“Historically one of the key indicators that the high-growth investment-driven model has reached its limits as a wealth creator (i.e. is no longer allocating capital efficiently) is when we see an unsustainable increase in debt,” according to Michael Pettis, a professor of finance at Peking University.

“Of course whether or not we have reached this point is still much debated, but I would argue that we started to see this at least five years ago. The surge in banking assets doesn’t give much comfort.”


Total assets in the Chinese banking system grew to 2.39 times Chinese GDP last year, yet another record, driven by heavy state-instigated lending beginning in 2009.

There are also reports of widespread off-balance-sheet maneuvers last year and this by would-be borrowers seeking to raise funds while avoiding official control. The asset figure is likely a large underestimate of both assets and of the stimulative effect debt is having on the economy.

The real problem with the end stages of a debt-financed growth binge is that policy makers are trapped regardless of what action they take. If Chinese authorities stamp on bank lending they are sure to leave many projects halfway completed and in default, a serious blow to an already shaky banking system. If, on the other hand, they allow loans to continue to be made freely we will be looking at much froth and many projects with highly uncertain economic underpinnings and value.

So, if the money actually is slowing what will be hurt? Chinese bank shares are already underperforming western peers, perhaps discounting the possibility of loans going bad if sky-high property prices sag. This looks a distinct possibility: housing sales were down 40 percent in Beijing in the first quarter.

Again, the risk here is that the banking system goes from overdrive to credit crunch if it sees and fears bad loans.

Analysts at Societe Generale suggest that hard commodities, such as copper and iron ore, would be particularly hard hit. If the slowdown is mild we would likely see only the most frothy markets hurt, but in the event of a hard landing, probably not a central scenario this year, the impact would be both big and global.

Longer term the question for China is how it dismounts from the tiger of an investment- and export-oriented economy and makes the transition to one with more domestic consumption. Letting the yuan rise strongly against the dollar would help. A large one-time revaluation of the yuan would also obviously help to control inflation and so might be a possibility.

Unless the transition to a more balanced economy is very gradual it will be disruptive. China, having helped to fuel a bubble in many assets, may well be the catalyst for the corresponding crash.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

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