Defaults bring market reality that China's economy needs
So far this week, China has seen a default by a major property developer and another by a state-owned company. Dubious firsts, to be sure, but they could not have come at a better time. They provide a dose of market discipline that China sorely needs.
So far this week, China has seen a default by a major property developer and another by a state-owned company. Dubious firsts, to be sure, but they could not have come at a better time. They provide a dose of market discipline that China sorely needs.
The country's 7 per cent growth in first-quarter gross domestic product cannot mask the flashing-red indicators that its economy is running into trouble. Industrial output, fixed-asset investment and retail sales have all slowed; land sales are contracting. The industrial sector's 6.1 per cent growth outpaced retail and wholesale trade, suggesting that the vaunted shift from manufacturing to services is not happening as hoped. Prices are falling almost across the board.
All this bad news puts pressure on Beijing to do more to stimulate the economy. Over the weekend, the People's Bank of China issued a bigger-than-usual cut to the ratio of reserves banks must hold, in effect adding almost US$200 billion worth of new liquidity. For now, leaders seem hopeful they can direct where that money goes. Regulators have clamped down on margin financing, for example, to discourage the funds from flowing into an overheated stock market.
Banks focused on agricultural development have received even deeper cuts to their reserve ratios, while the authorities have encouraged China's big policy banks to lend to small and medium-sized enterprises and strategic projects.
All this comes on top of an earlier reduction in the reserve ratios and two rate cuts. Yet demand for loans remains sluggish, because companies are already heavily indebted. The central bank might need to cut rates again.
The danger in this is that a new wave of easy money might only add to what is already one of the world's scariest debt piles.
The stimulus Beijing unleashed after the global financial crisis swelled China's total debt from about 150 per cent of GDP in 2008 to more than 250 per cent today. Although credit growth has slowed, it is still higher than nominal growth, so the debt-GDP ratio continues to rise. That does not guarantee a crash, as some are predicting. But once debt reaches these levels, it becomes a drag on growth, as more and more loans go into patching holes rather than productive investments.
Further rate cuts could worsen China's already inefficient allocation of credit, allowing new loans to prop up ailing state firms and property developers.
This week's events should help clarify the risks for all concerned. Until now, the government has prevented such defaults, for fear of contagion. (Even after allowing panel maker Chaori Solar to go bust last year, Beijing stepped in to make bondholders whole.) Yet unless borrowers and creditors believe there is a cost to failure, they will continue to make bad decisions and deepen the risk of a financial crisis.
By allowing Kaisa Group Holdings, a high-profile developer, to miss US$52 million in interest payments on Monday, and Baoding Tianwei Group, a state-owned maker of power transformers, to do the same with a US$13.8 million payment due on Tuesday, China may be signalling that the age of bailouts is over. In Kaisa's case, markets had already priced in the likely default and have taken it relatively well.
Premier Li Keqiang has implied that the government will allow "case-by-case" defaults as long as they do not pose systemic risks. More clarity on where Beijing draws the line would help: if investors had a better idea which firms and financial products will be protected, they would be able to price risk for those that would not be. Before China opens up the stimulus spigots again, it would help to know who might get washed down the drain.