Xi Jinping’s great wall of credit starts to crack

This week’s economic statement from China’s politburo contained what appeared to be core contradictions.

With Australia reeling from Bankgate, and with the phony trade war launched by Donald Trump still riveting international attention, it’s understandable that this week’s economic statement from China’s politburo, containing what appear core contradictions, received scant attention.

But it is triggering a few discreet alarm bells, including from one of Australia’s top experts on the Chinese economy, who believes that a debt-triggered crisis is inevitable in the medium term.

The politburo, at a meeting chaired by President Xi Jinping, said China would further boost domestic demand to ensure the stability of the economy.

This would be a priority, it said, even while restating the fight against the “three tough battles” — the prevention of risks, poverty alleviation and pollution control, while also continuing to cut overcapacity “in a lawful and market-based way”.

Partly as a result of moves to increase demand, China’s economy grew 6.8 per cent in the first quarter, well above Beijing’s target of about 6.5 per cent for the calendar year. And soon after this growth figure was announced, the central bank cut the amount of cash that banks must keep in reserves.

This, Reuters noted, was raising “concerns among investors about the risks to China’s economic growth outlook, and whether Beijing is backsliding on its promise to reduce debts”.

It is also reinforcing the longstanding concerns of Stephen Joske. He was the representative of the Australian Treasury Department in Beijing, then directed the Economist Intelligence Unit’s China forecasting section, and was after that the Beijing-based senior manager (Asia) of Australian­Super.

Joske had previously been known as a cautiously optimistic analyst of the Chinese economy.

That changed in late 2015, when he perceived that the country was facing “not merely a cyclical problem, but a challenge threatening the structure of the financial system”.

While more recently Beijing has belatedly recognised that it faces a huge debt-fuelled issue, Joske told The Australian that “the measures to counter it are not enough to contain the problems the Chinese government set in train”.

He dates the key misstep as happening in October 2015, when Xi introduced the ambitious growth target of doubling China’s economy in a decade.

“It wasn’t widely appreciated at the time just how strong that commitment of Xi was,” Joske said.

“To achieve that commitment required truly horrific amounts of credit being pumped in to the ­system.”

Thus despite today’s cyclical efforts, “structural adjustment is not making progress. Monetary policy has been tightened but there are no structural improvements.”

Most ominously, the credit-to-GDP ratio was still growing, Joske said. Growth has been slowed, from about 8 per cent to about 6.5 per cent, but this hasn’t been sufficient to reduce the size of the problem.

In policy terms, it’s about a simple trade-off: taking some pain upfront, to avoid a bigger dislocation in the medium term — about five years. “Every time the government has been confronted by that challenge, it has decided instead to go for growth.”

The constant reaffirmation of the growth target of doubling the economy, he said, was the clearest indication that the debt threat remained acutely live.

“There has been an obsession with flooding the financial markets with liquidity, keeping interest rates low, even while Beijing has been tightening monetary policy. This is not a combination of policies that is possible in other countries, but in such a controlled system, it can be achieved in China.”

Attempts to rein in credit have been too half-hearted to restore health to the financial system, Joske said. The most damage has been caused in the most obscure area — that of local government financing vehicles.

He said: “One of the reasons so many people have been getting China wrong is the extent of the attempts to disguise lending from regulatory scrutiny.”

Regulators were doing their best to control risk, he said, but key directives from the top would not let growth rates weaken, ensuring that excessive credit continued to flow through the banking system.

It was necessary, he said, to strangle offshore investments of private and government firms to keep foreign reserves stable — a move which started a year ago, but which has been riddled with loopholes. “It’s a question of when the thing will give way,” he said. “In four years or so you’ll see something pretty scary happening.”

It’s true that the Chinese party-state and its leader Xi appear all-powerful. “But that doesn’t mean they don’t make mistakes. From my perspective the stimulus started in 2015 was inappropriate, it was way too big.”

Micro-managing the volatility in the interbank market and the yuan offshore market were other examples — “and the ham-fisted handling of the stockmarket bubble” in 2015. “Policy mistakes happen at various levels quite regularly in China, and choosing growth over short-term pain shows they are not fully aware of the size of the risks.”

China had huge savings, but that wouldn’t stop a financial crisis, he said. Those savings are being repackaged in a way that makes them more volatile, and subject to panic. During 2016, China’s foreign exchange reserves fell by about $US1 trillion ($1.3 trillion), to about $US3 trillion, as everyone shifted money out of the country. The rest was being carefully guarded, but could evaporate quite quickly in a few years, Joske warned, making it the most likely trigger of a financial crisis.

China was entering a new stimulus period in the next few months, as revealed by the Politburo this week and this would feed capital outflows, he said, potentially triggering a devaluation of the yuan, causing a shock to a domestic system not prepared for one. Unless the growth target was reduced, he said, this problem would keep festering.

“China’s system is built around targets. It needs to send a signal that it will tolerate much lower growth, at first 5 per cent, and then below that. But politically it is not prepared to take the pain upfront, because that would hit the housing market, which would mean middle-class suffering, a loss of working class jobs in construction, and social unrest.”

There were risks to Australia, too, Joske added, with hard commodities, tourism, the property market and students all potentially prone to any substantial slowdown in China — where a global financial crisis-like event would cause a big loss in purchasing power. Sombre thoughts from an economist with very serious China experience.