China's Potemkin economy

Over-investment and a failure to write off bad debts will create progressively less economic activity.

Two views prevail when it comes to China’s debt crisis: pessimists are concerned about a catastrophic crash, while optimists predict a soft landing as gradual reforms correct the systemic issues.

The crash scenario is predicated on continuing increases in debt levels and over-investment, as policy adjustments are fatally delayed and authorities are ultimately forced to tighten credit aggressively, triggering failures in the financial system and a sharp slowdown in growth.

Weaknesses in financial structures exacerbate the money-market tightening, causing liquidity-driven problems for both vulnerable smaller banks and the shadow banking entities. The rapid decline in credit availability results in problems for leveraged borrowers, such as those in local governments and property sectors. The larger banks that are likely to benefit from the flight to quality are unable or unwilling to expand credit to cover the shrinkage from smaller banks and the shadow banking sector, due to risk aversion or regulatory pressures.

The deceleration in credit growth and liquidity results in lower levels of economic activity.

Foreign capital inflows that have enabled the central bank to provide liquidity to the financial system slow and then reverse. At the same time, capital outflows increase — especially from corporations, the politically well-connected and the wealthy — driving further contraction in credit.

Optimists counter that high debt levels are manageable because of high growth rates, the domestic nature of the debt, high savings rates and the substantially closed economy. They argue that the banking system has low leverage, a large domestic funding base and low levels of non-performing loans. They also rely on the high level of foreign exchange reserves and modest levels of central government debt, at least by developed country standards.

The optimists believe that reform programmes, albeit slow in implementation, will ensure a smooth transition from investment to consumption. Deregulation and structural changes will improve the resilience of the financial system.

Third way

The central government is seeking to steer a middle path, which is both difficult and has significant risks.

The strategy will entail continued credit expansion, providing liquidity, managing non-performing assets and using transfers from households to the financial and corporate sector.

The central bank will continue to provide abundant liquidity to the financial system through a variety of mechanisms. Chinese authorities subscribe to the theory that “a rolling loan gathers no loss”. Authorities have altered regulations to allow local governments to issue public bonds, for the first time in 20 years.

Shadow banking defaults will also be managed. Where considered appropriate, banks and state entities will intervene to minimise investor losses, by taking over the loans or re-integrating assets into regulated banks. As in previous Chinese episodes of bad lending, non-performing loans will be sold to existing asset management companies, established to deal with previous banking crises, to avoid a banking crisis.

In effect, instead of resolving the debt problems, the Chinese government will oversee a process of supporting over-indebted borrowers and the banking system. As in a shell game, bad debts will be shuffled from entity to entity, delaying the recognition of losses.


The ultimate price of this strategy will be to lock the Chinese economy into a lower growth path with the risk of a de-stabilising crash.

Over time, increasing amounts of capital and resources will become locked into unproductive investments that do not generate sufficient returns to service the debt incurred to finance it.

The cost will be borne by households, with slower improvement in living standards and erosion of the value of their savings.

Authorities will have to keep saving rates high to provide the capital needed to pursue this strategy. They will ensure that the bulk of funds remain in the form of low-yielding deposits with policy banks, which can be directed by the central government as required. Interest rates will remain below inflation. Banks will need to maintain a large spread between borrowing and lending rates to ensure sufficient profitability to absorb the cost of non-performing loans. Borrowing rates and the cost of capital will also need to be kept low to support the investment strategy and also reduce pressure on unprofitable or insolvent businesses.

The loss of purchasing power of household savings will provide the economic basis for the transfer of resources, amounting to as much as 5% of GDP, to banks and to borrowers, primarily SOEs and exporters.

The necessity of high saving rates will impede the rebalancing from investment to consumption. It will also impede the development and deepening of the financial system. China will also have fewer resources available to improve health, education, aged care and the environment.

In the short run, continued mal-investment and deferring bad debt write-offs will provide the illusion of robust economic activity, but households will discover over time that the purchasing power of their savings has fallen. Wealth levels will be reduced by the decline in the prices of overvalued assets and borrowers will find that their earnings and the value of their overpriced collateral are below the levels required to meet outstanding liabilities.

China’s Potemkin economy of zombie businesses and banks will create progressively less real economic activity. FA

Satyajit Das is a former investment banker and works as a consultant in the area of financial derivatives and risk management. He is the author of a number of key reference works on derivatives and risk management, as well as Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.

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