China has seen a substantial credit-fuelled investment boom over the past decade. Credit to the private non-financial sector has grown from around 100% of GDP in 2000 to around 180% in 2013. This rate of increase is more dramatic than in most of the crisis-hit nations in the Eurozone.
Borrowing to invest (especially in a developing economy like China) is not a bad thing, provided that investment brings future economic benefits. However, non-performing loan levels at a 2 year high suggest this has not always been the case and underlines the need to rein in lending . This has already begun: new total social financing (a broad measure of liquidity and credit) fell more than 50% to 938.7 billion yuan in February from the previous month.
A hard or soft landing?
A raft of disappointing recent data suggests the risk of an economic slowdown in China this year. The latest purchasing managers’ index for manufacturing fell for the fourth consecutive month in March to a 7-month low. Annual growth in industrial output fell to 8.6% - strong by Western standards but the weakest growth rate for China since the global financial crisis.
Investment fell 17.9% year-on-year, its weakest pace since 2000. Exports also disappointed, falling by 18.1% in February, even after accounting for distortions caused by the Lunar New Year celebrations .
Finally, interbank markets have been unusually volatile. Banks suffered a liquidity crunch in December when interbank lending rates almost hit 10%. A “western-style” credit crunch is unlikely given the state’s involvement in the banking system, as subsequent intervention by the central bank showed. But continuing volatility could mean higher lending rates for riskier borrowers, including SMEs.
An ambitious reform agenda
2014 is looking like a landmark year for reform in China across many sectors as the government seeks to reduce over-capacity of production. The historic default of Chaori (an otherwise unimportant solar cell maker) is indicative of the increasing liberalisation of markets. However, there are concerns that these reforms may be watered down in light of downside risks.
For example, a sharp slowdown in lending could weigh on growth, putting pressure on the central bank to loosen money supply to support the recently reaffirmed 7.5% growth target.
Highly-leveraged SOEs may be next, given the strong links between highly-indebted local governments, state-owned enterprises and banks. Risks to the quasi-public sector would surely see a roll-back on reforms.
Reforms are needed
These risks to growth also underline the importance of these much-needed reforms. The transition from the exports and investment-led growth model to a domestic consumption and services model will necessarily slow long-term growth, but it will reduce China’s vulnerability to external shocks and ensure sustainable growth. Opening up the banking sector to private capital will boost competition in financial services and reduce dependence on shadow banking. Pursuing these reforms may have some transitional costs, but are necessary to secure sustainable growth in the long-term for China.