Analysis | Debt and deflation darken China’s economic outlook
Mainland economy faces biggest risks in debt and deflation, with growth also hindered by industrial overcapacity that may take a while to resolve
Debt and deflation are the two biggest risks facing the mainland economy and may take years to resolve as a slowdown looms.
While a Japan-style, demand-starved deflation cycle is unlikely - real economic growth of about 7 per cent, high by international standards, precludes it - China's high debt and massive industrial overcapacity are major impediments to healthy growth.
"Japan reminded us very clearly of a story we have seen many times before in history," Peking University professor Michael Pettis told the . "The combination of very high levels of debt and excess capacity can lock an economy into a self-reinforcing spiral in which high debt levels put downward pressure on both consumption and investment, causing a further increase in the real debt burden."
Yu Yongding, a professor at the Chinese Academy of Social Sciences - the mainland's top economic think tank - thinks it could take five years to eliminate the economy's excess capacity.
China has been suffering disinflation of late. Consumer prices are rising at their slowest in five years at 1.5 per cent, while prices at the factory gate have fallen for 34 consecutive months.
The ratio of corporate debt to gross domestic product rose to 137 per cent in the third quarter of last year from 92.1 per cent in 2008, according to JP Morgan.
Sectors with the highest leverage are mostly those with excess capacity, such as steel, coal and property, as companies in those industries borrowed heavily to finance their expansion during the 2008 global financial crisis. As the real estate market slumps and economic growth slows, the odds are rising for more debt to sour.
Mainland banks have set aside about 1.3 trillion yuan (HK$1.62 trillion) in provisions since the end of 2008, according to estimates from BNP Paribas. Bad-debt write-offs leapt 76 per cent in the third quarter from a year earlier as banks sought to prevent non-performing loans accumulating on their books.
Local government debt has also soared. JP Morgan estimates it has grown to 21 trillion yuan from 5.57 trillion yuan in 2008 and could pose a serious challenge this year as the new Budget Law takes effect.
Beijing has ordered a reclassification of debt based on risk levels, which may cause some of the debt to lose the implicit guarantee of the local authorities. That may cause defaults to rise in the short term but is expected to help curb financial risks in the long run.
Yu said maintaining stable economic growth would be necessary as a sharp slowdown would worsen financial vulnerability. "Growth must be slowed but there should be a minimum growth rate, which is necessary not only for job creation but also for financial stability."
The leadership has stressed that stabilising growth would be a policy priority this year. Economists widely expect the annual growth target to be lowered to about 7 per cent.
Low inflation offers room to further relax controls on the government-regulated prices of utility, energy and water. It also gives the central bank room to further reduce interest rates, although a cut in November was seen as counterproductive as it caused speculative funds to flood the stock market rather than pushing down financing costs.
"The trade-off is that easing monetary conditions could lead to faster GDP growth and higher inflation but also risk reigniting credit growth. The authorities need to find a happy medium," said Standard & Poor's Asia-Pacific chief economist, Paul Gruenwald.