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The Road to Ruin?

04 October, 2017John Graham

China’s debt-to-GDP ratio reached an eye-watering 304 per cent in May of this year, according the International Institute of Finance. Since Chinese growth continues to rely largely on credit-driven investment, the likelihood of a debt crisis and a hard landing, although small, is steadily growing.

pexels-photo-94654According to Professor Michael Pettis, China has perhaps 2-3 years to implement the necessary reforms before a hard landing becomes unavoidable. When asked about the debate surrounding a ‘hard landing’ vs a ‘soft landing’, he replied:

“The whole hard-landing/soft-landing discussion misses the point. The options China faces are between a hard landing in which GDP growth drops sharply to below zero for a few years and unemployment soars and, far more likely, a long landing in which GDP growth drops gradually and for many years to levels well below half the current rate but without a substantial rise in unemployment. What determines the outcome is how quickly and aggressively Beijing tackles credit growth.”

China’s reluctance to tackle credit growth comes down to one thing: the intertwining of politics and economics. Approximately two thirds of Chinese corporate debt is owed to state-owned banks, and since state-owned entities (SOEs) get more favourable access to credit from these banks, they account for most corporate debt. In principle, of course, the Chinese Communist Party (CCP) could enact economic reforms and rein-in credit growth, but that would mean laying off tens of millions of workers, a recipe for nationwide political crisis.

The CCP certainly does not shy away from using the full force of the state to enact policy when they deem it necessary; but to throw millions out of work without an adequate social safety net for them would damage its credibility and perhaps even its continued grip on power. It will not be lost on the CCP that most one-party states that do not provide wealth for their citizens have very short lifespans.

The intertwining of the state and the national economy also complicates the question of debt management. With SOEs heavily indebted to state-owned banks, the Chinese state effectively owes money to itself. This means that China’s mounting corporate debt burden is less a ticking time bomb and more a funnel, draining larger and larger amounts of capital from the more productive sectors of the economy to subsidise state-owned zombie corporations.

A fundamental question with regard to debt, of course, is how much of it is being put to productive use and how much needs to be written off. In March of this year, Bloomberg reported that the NPL ratio at four of the big five Chinese banks had tapered off at around 1.5 per cent (the Agricultural Bank of China reported an NPL ratio of 2.4 per cent). Such low NPL ratios ought to imply very little trouble for these banks, let alone for their debtors.

It may well be, however, that these numbers are flattered by a policy of 'extend and pretend'. The Chinese state can, after all, require state-owned banks to continue extending credit to politically-favoured SOEs in order to roll over the old debt. If the old debt is being repaid, on time and in full, then it is not technically ‘non-performing’. What suggests that the numbers may be massaged by “extend and pretend” is the so-called “credit gap” – the gap between credit growth and GDP growth. The IMF notes that it is often an “indicator of brewing problems” and that the credit quality in “shadow” markets can be worse than at banks.

Despite mounting calls for economic reform, China appears to be doubling down on its current model of credit-fuelled investment, which means that more productive sectors of the economy will continue to be forced to subsidise the bloated and inefficient SOEs for some time. Much of this investment is being directed towards the One Belt One Road initiative – an ambitious programme of infrastructure development across Asia – rather than to domestic projects, but the same problem of generating adequate returns-on-investment remains. For this approach to be remotely sustainable, GDP growth and labour productivity growth would have to at least match, if not exceed, credit growth. However, as the figure below shows, the 'credit gap' is stubbornly large.

Figure 1, Source: Bank for International Settlements

The challenge of deleveraging and economic reform is compounded, however, by China’s demographic problems, namely, a working age population which is set to shrink dramatically over the coming decades. To make matters worse, China’s retirement age is 60 for men and 50 for women (55 for female civil servants), a state of affairs arising from the need to ensure employment for young graduates, a demographic group prone to destabilising political activism. By contrast, the average retirement age for OECD countries in 2014 was 65 for men and 63.5 for women. The retirement age in the UK will be equalised for both genders at 65 in 2018, whereas China plans to raise the retirement age for both genders to 65 by…2045.

The relaxation of the one child policy to a two child policy – even if it results in the expected increase in the birth rate – will not produce measurable economic results for several decades, and since having one child has been the social norm for decades, the policy’s effect may be limited. In the meantime, China is only now in the process of creating a national pension system and a national healthcare system. The financial burden of these will be substantial, but could be eased by raising the retirement age much earlier than 2045 – a potentially very unpopular measure, but even this would only put a modest dent in the problem.

Figure 2, Source: UN Population Division (median estimates)

On the demographic front, the key index to watch is the potential support ratio. This is the ratio of people aged 15-64 to those aged 65+ which corresponds to the number of workers per retiree. According to projections by the UN Population Division, China’s PSR is set to more than halve from 7.5 to 3.1 by the year 2040, and then drop again to 1.9 by the year 2060. Japan’s PSR on the other hand will drop by a comparatively small amount and even recover slightly in the second half of this century. The black line corresponds to the present year, 2017.

Comparisons to Japan are common since Japan is also burdened with an ageing population and excessive debt, both of which are causing economic sluggishness. But Japan’s problems may turn out to be milder than China’s in the long term. Not only is China’s per capita GDP more than four times smaller than Japan’s, but its GINI coefficient (a measure of income distribution across a population where 1 means perfect inequality and 0 means perfect equality) stands at approximately 0.556, versus 0.33 in Japan.

This means that China has to battle the challenges of deleveraging and an ageing population alongside extreme poverty and income inequality. China is only now setting up national pension and healthcare systems, and the systems which already exist are still decades behind those of Japan. Depending on how quickly China implements the necessary reforms and deleveraging, the waning of bearish sentiment towards the Chinese economy could be a positive turning point, or the calm before the crash.

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