Why China is set to hit the Great Wall of Debt

China’s Great Wall of Debt is less visible but more threatening

The engine of global growth is set to slow sharply and that will have implications for investors all around the world, author Dinny McMahon tells Merryn Somerset Webb.

A decade ago analysts talked about China as a “miracle economy”. No one could quite believe the magnitude of its change. We were stunned by the speed of income growth, the scale of the infrastructure projects and huge volume of exports coming out of the country. We aren’t stunned any more. These days we see Chinese economic power as less miracle than inevitability. We don’t talk about if China will become the biggest economy in world. We talk about when. Along the way, the idea of Chinese exceptionalism has taken hold. The Chinese, we tend to believe, are different – they have found a path to fast GDP growth that doesn’t rely on democratic capitalism (the route that has worked so well for the rest of us) and, better still, avoids the boom-bust cycle that comes with it.

This is an attractive idea. But falling for it is a huge mistake, says Dinny McMahon, author of China’s Great Wall of Debt: Shadow Banks, Ghost Cities, Massive Loans and the End of the Chinese Miracle. No-one gets to avoid the cycle. The Chinese economy has “been overstimulated for far too long”. Most people think the main driver of growth in China is exports. But that isn’t really so. In fact it is driven almost entirely by debt-financed investment – in infrastructure, in housing and in all the factories needed to produce all the supplies for construction. All this kicked off a decade or so ago when the global financial crisis decreased America’s previously insatiable demand for Chinese exports. China’s response was massive internal stimulus funded by bank lending.

That stimulus never really stopped – by the end of 2016, China’s debt-to-GDP ratio had hit 260% (up from 160% in 2008). The problem, says McMahon, is not that China doesn’t want to pull back, but that it can’t: the need for GDP growth is “hard baked” into the political system. At local government level, officials have long been judged by their ability to grow the economy. Those at state-owned enterprises have been judged by how fast they grow the companies they run. And at the top, if Xi Jinping wants to deliver the “national rejuvenation” he has promised, growth it is an absolute imperative.

Heaven is high and the emperor is far away

But just because China needs growth does not mean it will get it. The rationale behind the idea that China is different comes down to the feeling that “Beijing is so big and so powerful” that it can fix anything. The problem is that “economies do not work like that”. Beijing is powerful enough to paper over a lot of cracks, but that’s not the same as stopping them forming through real reform. Power in China is very decentralised, says McMahon – party officials have a lot of ability to “selectively implement or to block reform”.

The definitive (and dangerous) characteristics of the local government debt problem, the vast industrial over-capacity and the horrible shadow banking sector all stem from local officials dancing to their own tune. The truth is that while the casual observer from the West can easily be conned into thinking that Xi is all powerful – that China is deftly run by a “technocratic elite” able to make tough decisions with efficacy and impunity – it isn’t. In a country where the law is more flexible than absolute, officials and financial institutions always find a “work-around”. Reform “never works”.

Hasn’t the dynamic begun to change, I ask? To a degree, says McMahon. The party is well aware of the problem – hence the recent political changes, the idea being to focus power in Xi’s hands, impose discipline on local governments and “raise the cost of obstruction”. Xi has also talked about going for quality of growth over just growth, working on cutting financial risk, aiming for more income inequality and dealing with pollution.

However, whether this power grab works or not, the “basic dynamic” across the economy remains the same (creative officials plus debt, debt and more debt). Note that whatever Xi says, he can’t afford slow growth (the non-performing loans problem is bad enough as it is, slowing growth will just make it look worse). The target is still 6.5%, and that’s more than China could generate without the creation of much more debt. So however good the intentions China has no choice but to keep leaning on the old model (debt-fuelled investment) as it tries to shift to an economy based on innovation, technology and import substitution.

This comes, of course, with no end of its own dangers – trade war being one of them. Note that the Made in China 2025 initiative, which is an attempt to move China’s economy up the value chain, aims to make the domestic content of products 70% by 2025 – the idea being that China should stop making so much of what it does not need (eg, more steel) and more of what it does. This is a direct challenge to American tech leadership, says McMahon, and the main factor in the current US-China trade conflict – here’s a reason why Trump’s tariff list focuses mainly on products included in the Made in 2025 plan.

Slow growth will change the world

So what prompts a Chinese crisis? In the end, it could be the authorities losing control of their managed exchange rate (the yuan saw its sharpest one-day decline against the dollar in 18 months on Tuesday). However the most likely outcome might be not a 2008-style financial crisis but a long period of very low growth – as is entirely normal in the wake of a period of fast, debt-fuelled growth. This will “change everything for the global economy”. The effect won’t be as immediate as you might think. China’s capital controls mean Chinese financial markets aren’t as connected to the rest of the world as you would expect. Chinese companies have borrowed relatively little from abroad (although the total has been rising quite fast recently), so foreign banks aren’t particularly exposed to potential crisis. At the same time the government has mostly borrowed locally (from insurance companies for example) and the rest of the world has very little cash tied up in China’s stockmarket.

“The linkages just aren’t there.” But that doesn’t mean a China crisis won’t hurt. It will. A decade ago you could have argued that China’s role was simply to be the “maker of cheap manufactured goods”, something that would have meant that – the materials China uses for infrastructure growth aside – a crash would have had little impact on global demand. “By running a huge trade surplus, China has generated disproportionately little economic activity in other countries relative to the size of its economy.” Even now, according to Morgan Stanley, only 12% of revenue at companies listed in China derived from shipping goods overseas. China has also made much of the seemingly foreign goods it consumes – Volkswagen clearly benefits from having half its global sales in China, but those cars are also made in China.

However as China has grown richer, it has started to buy the things it can’t produce at home. And in size. Chinese ticket sales are so important to Hollywood, says McMahon, that studios “are actively casting Chinese actors”. Chinese buyers are the most important market for luxury goods (they buy a third of the luxury handbags sold every year). They buy experiences too. In 2016 there were 600,000 Chinese students in the US, UK and Australia. They are also driving all the growth in global tourism and spraying cash wherever they go. They spend more abroad than anyone else (so much so that, in his book McMahon notes that the Japanese have a word for it: “bakugai, or explosive shopping”). China also buys technology: 5% of all Boeing planes, for instance.

Finally there is agriculture: the Chinese are huge consumers of everything from Maine lobster to American cranberries. Add it all up and on OECD data China now imports about 10% of the world’s goods and services. The key point here, says McMahon, is that the numbers are huge. It is impossible to say how China’s problems might affect such a range of products, let alone the global economy as a whole – but pretty dim to think they won’t.

The party endures

However, only to look at the immediate economic effect on the West is to miss what might be a more important dynamic – politics. Income inequality in China is some of the worst in the world. But, thanks to the stunning improvements in personal prosperity – no-one under 40 has ever known either recession or GDP growth at less than 6.5% (on official statistics, anyway) – the Chinese are hugely optimistic about the future. In his book, McMahon points to surveys showing that 80% of people think their children will have a better standard of living than them (in the US 60% think it will be worse). People will put up with a lot for economic growth – and the Chinese have (corruption, miserable working conditions, residency restrictions that separate them from their children, extreme inequality and curtailed freedom). But they’ve done so in exchange for constantly rising prosperity.

What happens if the economy breaks the deal, particularly if all the things that really worry the new middle classes (food safety, pollution, quality of domestic education) aren’t sorted out? The default opinion in the West is that the communist party will collapse. It won’t. It survived the Great Leap Forward, the Cultural Revolution, the Tiananmen protests and the breaking of the iron rice bowl. It can weather this, says McMahon. But unrest could force a change in political direction. To populism? Nationalism? Authoritarianism? We don’t know. What we do know is that “China doesn’t need to experience a change in government to experience a change in governance”. And given the size of China, that’s something that will affect us all. Most people think this is China’s century, says McMahon, the result of “40 years of hard-won prosperity off the back of tough minded reform and sacrifice,” as he puts it in the book. But without radical reform, it can’t possibly be.

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