China Can No Longer Drag the Global Economy Along
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China Can No Longer Drag the Global Economy Along


NEW YORK – January 30, 2019

In the past 30 years, the Chinese economy has shown incredible growth, growing by an average of 10% a year. The country vigorously made its way into the ranks of world leaders, literally pushing other applicants with its elbows, and since 2009 China has been in the forefront, dragging the global economy along by astronomical debt stimulus.

In the 2017 Economic Forum of Davos, President Xi Jinping noted that China has been responsible for 30% of global growth since 2008.  When the financial crash of 2008 morphed into a global recession, Chinese leaders reacted quickly. They started massive infrastructure programs that carried the economy to a renewed upward trajectory. These programs were financed by credit issued by state-controlled banks. But, once the stimulus was started, they could not turn it off. The former engines of the global economy, the US and Europe, remained weak. Without continuous, massive stimulus, the Chinese economy would fall into a recession. This was not an option for Chinese leaders as their mandate from the people relies heavily on increasing living standards and full employment (see, e.g., the book by Dinny McMahon). So, the credit machine was kept running full-blast.

In 2015, Chinese leaders tried to stabilize the economy by tightening credit especially to the manufacturing sector. This led to a slump in the Chinese housing market, which had already weakened in 2014. Because real estate had been the backbone of Chinese economy for the past two decades, the overall economy soured quickly. The Chinese stock market started to fall, and the global economy hiccupped. Another round of massive debt-driven stimulus, this time transmitted through the “shadow banking” sector, was enacted.

During 2016 and 2017, China unleashed a never-before seen credit bonanza during which the size of the “shadow banking sector” tripled (see Figure 2). Combining the credit banks extended to the non-financial sector and the off-balance sheet items of banking institutions, by the end of 2017 the total assets of the banking sector stood at a horrific and thoroughly astonishing 563% of the GDP.

Figure 1. Bank credit extended to the non-financial sector and the outstanding off-balance sheet of banking institutions/GnS Economics, BIS, PBoC

Even disregarding the off-balance sheet items, China completely surpasses all historical thresholds preceding financial crises compared to the level of economic development (see Figure 3). Between the first quarter of 2009 and the second quarter of 2018, an incredible 56% of all credit issued to non-financial private sector globally has come from China.

China has been able to accumulate such astronomical levels of debt because it had something similar to a command-and-control grip on the banking sector. It can order banks to lend. However, this has an obvious drawback. A growing share of such loans will go to non-productive investments each year. This is likely to be the biggest reason why the total factor productivity of China has fallen since 2012. It grew like clockwork throughout the first eight years of the new millennium and again in 2010 and 2011, but then a massive shift occurred. This has been visible also at the global level.

Figure 2. The GDP per capita (horizontal; constant 2011 international $), credit-to-GDP ratios for non-financial private sector (vertical) and financial crises/GnS Economics, BIS, World Bank

 Eventually, any extended lending spree will lead to an impasse where households and companies will not—or cannot— absorb any more credit. Their need to meet their obligations forces them to start paying back debt. In a highly-levered economy, this means that the relentless rise in asset prices eventually halts, and then starts to decline—sometimes precipitously. The economic actors default or declare bankruptcy, and suddenly the whole asset universe starts to lose value. This the ”Minsky Moment.”

China has been fighting against this since 2016 with draconian capital controls, increasing restrictions on the financial media and by implementing large-scale liquidity operations whenever needed. It has been able to slow down the extension of credit, but even so, it still grows faster than GDP. Notably, the first two quarters of 2018 saw the biggest increase in credit to the non-financial sector since 2009 (see Figure 3). However, this credit binge has resulted in relatively little GDP growth (which begs the question: how low would it be without it?) and several indicators suggest deepening weakness ahead.

China’s problems could turn out to be temporary if Beijing managed to maintain good trade relations with the US. But this turned out to be another chimera. The trade war that broke out between the US and China caused damage to its exports and increased its import costs at the very moment when the country was counting on a stronger trade balance surplus so that Beijing could finance more debt.

Currently, trade collapses and China is mired in debt, which it can neither repay nor refinance. And this situation marks the end of a history of miraculous economic growth in China and the beginning of a period of economic recession and potential social unrest.

 According to Tuomas Malinen, because of the ever-ballooning balance sheets of banks and debt, China simply will not be able to debt-stimulate its, or global, economy out of a recession similarly as it did after 2008. That is why the day of reckoning is approaching.

Presently, the world economy simply cannot cope without a continuous stream of economic stimulus: debt creation, most notably from China.  And economic history clearly and consistently illustrates how credit bonanzas, like the one ongoing in China, end (badly). But, the credit bubble of China is just an end-point of a long line of consecutive credit bubbles, which started in the 1970’s, or even earlier.

Central banks, with the exception of the Fed in early 1980’s, have kept the global credit machine humming by intervening every time a serious contraction started to emerge. This has led to the massive accumulation of global debt over the years, which has reached an epochal, and practically-incomprehensible $244 trillion, the equivalent of more than three times global GDP. China has been in the forefront since 2009.

China bailed out the global economy in 2009 to everyone’s relief, but now, the consequences of those policies threaten to bring everything down.

Author: USA Really