Chinese credit crunch hinges on where the debt is

Scott Morrison says we’ve got five years or so to ‘increase our resilience’ because of China’s growing debt problem.

Scott Morrison is hedging his bets over China’s bubble. Picture: Kym Smith

Scott Morrison says we’ve got five years or so to “increase our resilience” because of China’s growing debt problem. We may not have that long.

China has become the great innovator of global finance: socialism with a credit bubble.

Eight years after the headquarters of capitalism, the US, had one of its periodic rediscoveries of the consequence of financial excess, the People’s Republic of China has discovered the bountiful alchemy of housing and debt. For the moment, the consequences of it remain undiscovered.

In an interview on Sky this week, the Treasurer used the proliferating predictions of a Chinese financial crisis to push the case for fixing the budget, which was a fair point.

If China’s debt-fuelled housing bubble does actually burst, Australia will need all the fiscal and monetary firepower it can get, and both are in short supply at the moment, what with the policy rate at record lows and the budget deficit at record highs.

But will such firepower be needed? That is the question. Will China’s obvious housing and debt bubble burst untidily, or will Karl Marx tidy it up?

Morrison implicitly acknowledged this possibility, which allowed him to hedge his bets: “(It) will be a matter of where the debt sits within the Chinese economy. Whether it sits in the SOEs directly and the local government and administrations or it sits in the central government level. At the central government level, their debt issues are far less dramatic. The debt issues arise in a lot of those other agencies, particularly in government but also in the private sector in China.”

That’s a pretty good summary of the position, which is that the state-owned enterprises and the banking system are intertwined and are both beneath the waves together, but the central government is fine and could probably recapitalise the rest.

How much would it take? A week ago, Fitch Ratings put the figure at $US1.1 trillion to $US2.2 trillion, or 11-20 per cent of GDP, and said this could double by the end of 2018 at the current rate of increase.

Fitch concluded: “We think that sovereign resources will ultimately be needed to help address China’s debt overhang.” It points out that this is already happening to some extent through the local government debt-swap program. The Bank for International Settlements, in another report published last week, came at it from another angle. It said China’s “credit-to-GDP gap” was 30 per cent, the highest in the world, and well beyond the danger level of 10 per cent. The credit-to-GDP gap measures the extent to which the ratio of a country’s total level of debt to GDP exceeds the long-term average.

Australia’s is currently about 5 per cent and the US is minus 10 per cent, so absolutely no problem there.

The main problem in China is not so much the level of debt — ­although that’s bad enough — it’s that so much of it has been wasted, with the result that credit intensity (the amount of credit needed for a given increase in GDP) is ­collapsing.

That’s because 50 per cent of China’s debt lies in the SOE sector, which is hopelessly unreformed and inefficient.

It’s not just China’s socialism that’s causing the inefficiency — Europe has an almost identical problem, which was highlighted (again) this week in a speech by ECB president Mario Draghi, in which he called for structural reforms and said long-term interest rates could rise only if there were more investment to lift growth and productivity.

In the past year, the combined sharemarket value of Europe’s banks has almost halved from about €600bn to €330bn, led by a huge fall in the price of Deutsche bank shares to a 33-year low.

They are probably all technically insolvent, in need of government support.

China’s need to reform its economy is more urgent than Europe’s. For the past two years, the authorities have been talking reform but avoiding it like the plague, while using credit to engineer a soft landing for growth.

Interest rates have been cut, reserve ratios requirements reduced and prudential controls loosened. According to Fitch, banks are being instructed to roll over loans to highly leveraged borrowers no matter how much overcapacity there is in their businesses.

And with a Politburo rotation due at the next Party Congress in 2017, it’s very unlikely that any tough reform decisions will be made in the short term — in other words, credit expansion will continue to be main source of growth, even as its efficiency continues to decline.

It’s not as if the government is unaware of the problem. At the G20 meeting in Hangzhou in September, President Xi Jinping campaigned for structural reform and said: “Following the old road of relying purely on fiscal and monetary policy leads to a dead end.” But talk and walk are strangers in China.

Does Australia have five years, as Morrison says, to get its act together before China’s economy blows up in a banking and financial crisis?

It’s impossible to tell. The official figure for non-performing loans in China’s banking system is 1.8 per cent, but the real figure is anything but that. Fitch puts it as high as 21 per cent.

But it’s also true that if push comes to bust, the government could probably step in and recapitalise the whole system; as Morrison says, it’s a matter of where the debt sits.