No country can be indifferent to China’s economy, especially not Australia. We’re more exposed to what goes on in it than just about any other nation. China has long been the biggest market for our commodities, such as iron ore, coal and wool. And now it is the largest foreign buyer of our services, especially education and tourism. The upshot? Many thousands of Australian jobs depend on the health of the Chinese economy.
Big Asian economies in our region – China, India and Indonesia – are bound to become even more important to us during this, the Asian Century. Our politicians like to dwell on the opportunities presented by the historic economic transformation to our north. But we’ll also need to be prepared for some nasty bumps along the way.
The aftermath of China’s enormous corporate debt bubble could well be one of them. For some years now China’s economic growth has been underpinned by an explosion in corporate lending. China has accounted for half – yes half – of all new credit created globally since 2005 according to the New York Federal Reserve. That’s a huge share for an economy that now only accounts for about 15 per cent of the global economy.
Alarm bells rang last August when the International Monetary Fund pointed out the trajectory of credit growth in China was eerily similar to countries that experienced painful post-debt boom adjustments in the recent past. This includes Japan in the 1980s, Thailand prior to Asian Financial Crisis and Spain prior to the European debt crisis.
The sheer pace of lending growth makes it likely many loans are going to marginal borrowers or unviable projects. A recent Oxford University study that evaluated 65 major road and rail projects in China concluded just 28 per cent could be considered “genuinely economically productive”.
The rapid expansion of China’s less regulated “shadow banking” sector adds to the complexity. The Reserve Bank has described China’s financial system as “increasingly large, leveraged, interconnected, and opaque”. Authorities have recently taken steps to reduce credit growth in China but it continues to expand at a rapid pace.
The Reserve’s latest review of financial stability published in April, said the risks continue to build. “The level of debt in China has risen significantly over the past decade to reach very high levels, with particularly strong growth in lending from the less regulated and more opaque parts of China’s financial system,” it said.
A new threshold was reached six weeks ago when international ratings agency Moody’s downgraded China’s credit rating for the first time in nearly 30 years. It warned China’s financial strength would “erode somewhat over the coming years” and predicted slower rates of growth in future.
Illustration: Simon Letch
Then last month the International Monetary Fund said economic reforms must urgently accelerate to “address the risk that the current trajectory of the economy could eventually lead to a sharp adjustment”.
The best outcome is for what economists call a soft landing. Under this scenario Chinese authorities would accelerate reforms, somehow scale back credit growth and clean up bad debts while economic growth keeps humming along at a healthy rate.
Illustration: Andrew Dyson
Despite the vulnerabilities, the Chinese government has a strong balance sheet. It will be able to absorb potential losses and deliver further economic stimulus if needed.
But as economist George Magnus, an associate at Oxford University’s China Centre, says “you can’t resolve a debt problem peacefully”.
Chinese authorities will have to make some tough policy trade-offs if they are to restore a more sustainable rate of credit growth. Any policy missteps could take a heavy toll.
In a recent speech, Treasury Secretary John Fraser said ominously that “it remains to be seen” if the risks to Chinese growth can be reined in successfully.
“We have plenty of experience in Australia with the challenges in making structural economic changes, so I do not envy my Chinese counterparts their task in such a large and populous nation,” he said.
A second possibility is that China manages to avoid a sudden financial disruption but instead muddles through as its props up zombie businesses and lenders while the credit binge slowly unwinds.
A third option is for “sharp adjustment” to cause a hard landing that takes a heavy economic toll.
Both the second and third scenarios would result in slower Chinese growth. And that would hit Australia in two ways, first by reducing the price of the commodities we export but also by reducing Chinese demand for Australian goods and services.
It is notoriously hard to predict when and how a credit boom will unwind in the most transparent of democratic systems. In a vast one-party-state such as China it’s even more baffling.
We can only hope a resolution comes sooner rather than later.
The Reserve Bank warns the longer this unsustainable period of debt-driven growth persists “the more likely it is that China’s economic transition will include a financial disruption of some form”.
By Matt Wade
Sydney Morning Herald