China is hooked on debt and banking on hope

China’s economy is performing much better than anyone expected, leading the International Monetary Fund last week to raise its predictions for China’s growth for each of the next five years. It is a performance bringing a warm glow to proceedings of the Chinese Communist Party congress in Beijing; some suggest it was engineered by the authorities with precisely that end in mind. President Xi Jinping would never permit a whiff of turmoil while he is securing his administration for the next five years.

Xi has put a premium on stability over market reform. State-owned enterprises retain unchallenged control of the commanding peaks of the Chinese economy, the currency remains tightly managed and fresh infrastructure programs are rolled out any time growth appears to falter. The sentiment of the times was captured by The Wall Street Journal in a quote from the head of the Chinese Academy of Fiscal Sciences, Liu Shangxi: “Risks are everywhere in the society, and now more than ever the government should play a bigger role.”

When China’s economy looked as if it were in trouble in late 2015 and early last year, with ham-fisted management of wild trading in the currency and the sharemarket raising questions about the competence of the authorities, the chill quickly spread to Australia. Export prices dived, the Reserve Bank cut rates and S&P Global threatened to strip Australia of its AAA credit rating as the budget deficit blew out further. The Chinese government’s answer to the big market moves for shares and the currency was heavy state intervention.

The benefits of the lift in China’s economy in the past year also are spilling over to Australia. Business is more upbeat about the outlook than at any time in the past decade, investment is rising, the trade balance is in surplus and even the federal budget looks better. Right now, we’re riding another China wave. Not since the last gasps of the British Empire following World War II has Australia had such an intense economic relationship with another country. China takes a third of our exports, is the biggest source of foreign students and tourists, and is the main source of growth in foreign investment.

Hard-hitting reports by the International Monetary Fund and the Reserve Bank in the past week have portrayed China’s economic resilience as an illusion, describing an economy hooked on debt. Tackling the addiction may bring a traumatic withdrawal, but allowing it to continue would risk something far worse. As the Reserve Bank puts it in its review of financial stability, “given the already high level of risk that has built up in the financial system, the authorities are likely to face a trade-off between strong regulatory action that could trigger financial and economic disruption, and a more cautious approach that may allow a further build-up of risks”.

The Reserve Bank acknowledges that Chinese authorities have taken steps to limit some of the riskier borrowing. But it adds: “The authorities’ commitment to moderate riskier financing could be tested if economic growth targets are threatened.

“The more that leverage and risky lending grow, the more likely that China’s economic transition will include a significant financial disruption of some form.”

Prophesying financial doom for China has been an industry for years. A 2002 Wall Street Journal feature was headlined: “In China, foundation is set for a banking crisis to erupt”. It cited Nicholas Lardy, still one of the pre-eminent authorities on China’s economy, as declaring that its banking system was insolvent, with all the preconditions for a crisis.

There is an urgency to the concerns being expressed now. The magnitude of its corporate debt is surpassing all records, with a large share of it propping up loss-making state-owned enterprises. The IMF says total bank lending is more than three times the size of China’s GDP. It has analysed 43 previous credit booms around the world and found none analogous with China’s that ended in anything other than financial crisis and recession. Much of the growth in bank lending has been to relatively unregulated non-bank financial institutions, the so-called “shadow banks”, which have been aggressively promoting wealth management products and property development. By lending through these institutions, banks avoid restrictions on their direct exposure to high-risk sectors.

The Reserve Bank says the lack of transparency increases the risk of contagion, as banks are likelier to withdraw from interbank markets when they are uncertain about the solvency of other banks. Losses in the shadow banking sector could cascade through the financial system.

The IMF says it would be impossible to curb the growth in dangerous shadow bank lending without hitting overall credit growth in the economy.

Treasury and the Australian government are alert to these concerns. In a speech last year, Scott Morrison noted that efforts to control growth in China’s debt were being sacrificed in the interests of sustaining growth.

The challenge for Australia’s authorities is to use these relatively benign times to strengthen Australia’s ability to withstand a downturn in our principal economic partner. When it comes, it will be too late to wish more had been done to restrain the growth of government and household debts, which the credit ratings agencies see as our chief vulnerabilities.