Don’t Breathe Easy About China Yet

While new factory data, and signs of a trade truce with the U.S., have investors feeling more bullish about China, most analysts now accept that GDP growth will inevitably have to slow if Beijing is serious about reining in credit expansion. Till now, China has met its GDP growth targets only because soaring debt allowed it to capitalize non-productive activity, i.e. value it at cost rather than its real economic value. The target could be 6 percent just as easily it could be 7 or even 8 percent: As long as local governments and state-owned enterprises had debt capacity, they could generate enough activity to meet almost any target.

What’s less-understood even now is that if China begins a serious deleveraging, reported GDP growth rates will fall by a lot more than expected -- by more than the amount of non-productive activity that had formerly been capitalized. This is clear from the historical precedents. In every modern case where countries enjoyed similar investment-driven growth “miracles” and then suffered painful adjustments, medium- and long-term GDP growth rates slowed much more than even the most pessimistic projections.