China Isn't Headed for a Financial Crisis
Ever since the 2008 global financial crisis, pundits have tried to guess which country could set off the next implosion. Last week, China seemed to put itself forward as a pretty good candidate, as markets around the world panicked over the risks posed by its slowing economy. Those fears, while valid, are overdone.
We know much more now about the factors that contribute to financial crises than we did before. Previous victims have all featured elevated risk factors such as rapid credit growth, poor public finances and asset bubbles. Those risks intensify when they develop in combination with one another.
Today's China certainly suffers from many of them. The Bank for International Settlements has warned that Chinese credit growth since 2008 represents one of the largest expansions in modern financial history. The Chinese credit-to-GDP gap, a widely used leading indicator of banking stress, stands at a global high of 25.4. No other country comes close: Turkey, the next on the list, has a credit-to-GDP gap of 16.6. Between 2007 and the end of 2014, Chinese and Hong Kong debt-to-GDP grew by 82 percent and 103 percent respectively -- more than twice as fast as virtually every other emerging market economy.
The International Monetary Fund warns that China’s government and contingent deficits total nearly 10 percent of GDP. Chinese economists have found housing price-to-income ratios well in excess of the long-term global average. Bad loans are seriously understated; Charlene Chu of Autonomous Research puts them closer to 20 percent. The world's factory is suffering from severe overcapacity and weak global demand for its manufactured products.
Still, it would be a mistake to look at this cocktail of factors and assume a crisis is inevitable. First, just because a country features elevated risk levels doesn't guarantee disaster. At nearly 400 percent of GDP, Japanese debt levels far outpace those in China, yet few fear a crisis in Japan. By the same token, Chinese home prices in relative terms have been much higher for a number of years than in the U.S. prior to the global financial crisis, without provoking a crash. While countries that suffer financial crises share common risk factors, not all countries with those risk factors succumb to crises.
Second, crises grow out of complicated, non-linear interactions of various factors, rather than a uniform and predictable sequence of events. In his book "Outliers," Malcolm Gladwell describes plane crashes as most “likely to be the result of an accumulation of minor difficulties and seemingly trivial malfunctions.”
Chinese leaders are acutely conscious of the “seemingly trivial malfunctions” in the economy that could prompt a crisis and have the tools to address them. Whereas Greece had to haggle desperately with Europe to obtain financing and the U.S. government provoked fierce argument over its corporate bailouts, China has moved swiftly to rescue failing firms to prevent a domino collapse. Authorities will censor market rumors, sell off billions in foreign reserves to prop up the currency, flood the banking system with liquidity -- whatever it takes to maintain stability. That doesn't mean they'll always make wise policy decisions. But those policies should at least reduce the likelihood of catastrophic outcomes.
Third, as with all things in China, the specter of a financial crisis is an intensely political concern. Even a publicly acknowledged slowdown would pose a threat to Communist rule, which is so dependent on the regime's claims to economic competence. Whereas the U.S. might be able tolerate the risk or losses associated with a crash and emerge stronger, Chinese leaders -- well aware of the fate of the Soviet Union -- can't afford to do so.
Should a financial crisis occur in China, it will be because all options to prevent such a profound dislocation have been tried and failed. Before then, no rescue attempt or bailout will be too outlandish to attempt. No policy, however absurd like maintaining credit growth at twice the rate of GDP growth, will be overlooked.
Indeed, the greater problem is that amid these efforts, the serious and painful restructuring China needs will be postponed. Truly slowing credit growth would prompt a wave of corporate bankruptcies and prevent the government from reaching its GDP growth target. Yet the alternative -- the continued buildup of debt and spread of lossmaking zombie companies across the economy -- only deepens the risk of an eventual crash. It’s true that a crisis would be the last possible outcome after many, many failures. The question is whether the cure will turn out to be worse than the disease.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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