Credit in China has been expanding far too quickly, according to a new warning issued last week. The result is excessive debt, asset price bubbles, and complex hidden risks that pose a major systemic danger to the world’s second largest economy.
This is hardly the first warning we’ve heard about the build-up of financial leverage in China. Supra-national organisations like the International Monetary Fund and the Bank for International Settlements have sounded the alarm repeatedly. In September, Standard & Poor’s downgraded China’s sovereign credit rating, citing the rapid growth of debt. And of course a coterie of confirmed China bears has been warning for years that massive capital misallocation could precipitate an economic collapse.
But last week’s warning was different from all of these. It really caused people to sit up and pay attention, because it came from the veteran governor of China’s central bank, Zhou Xiaochuan. And Zhou’s words were no throwaway comment; they were included in the central bank’s official follow-up to the policy platform outlined at October’s Communist Party congress.
What’s more, it was not the first time that Zhou has sounded a clear note of caution. Last month he warned that China may be facing a dreaded “Minsky moment” and a subsequent financial crisis.
So what exactly did Zhou mean by that? And if China’s most experienced and respected financial regulator is worried about the accumulation of risk in the system, surely the rest of us should be running scared too? Perhaps not. Admittedly, on the surface, there are some signs that China could be approaching the sort of Minsky moment that precipitated the US financial crisis of 2008. Named after the US economist Hyman Minsky, who devoted much of his career to studying financial crises, this is the point at which a speculative bubble bursts, triggering a collapse. Minsky’s key insight was that financial systems can be inherently unstable, and that calm conditions tend to breed storms in a runaway positive feedback loop. So, when things are going well, lenders relax credit standards and investors leverage up in the hope of earning higher returns.
At first, prudence prevails. Companies borrow only as much as they can repay from cash flow. But as asset prices rise, they are joined by more speculative borrowers, who can cover interest payments but count on capital gains to repay their principal. Finally the system enters full-on bubble mode, propelled by “Ponzi” borrowers, who can afford neither interest nor principal payments and rely on excessively easy credit and ever-rising asset prices just to stay afloat.
Alas, credit-fuelled asset bubbles can’t last forever. Sooner or later the Minsky moment arrives. Something dents confidence, asset prices retreat, lenders make margin calls, and leveraged investors are forced to sell assets in order to raise cash, compounding the falls in prices. Before you know it, another positive feedback mechanism has kicked in, only this time to the downside. The result is financial collapse and a painful recession as the economy deleverages.
At first glance China does show some of the signs. Certainly debt has grown rapidly, and much faster than the economy, from around 150 per cent of gross domestic product 10 years ago to somewhere around 260 per cent today. Much of the borrowing through China’s shadow banking market resembles classic speculative behaviour. And anecdotes abound of investors leveraging far beyond their means even to pay interest in order to pile into fast-rising property markets – typical Ponzi behaviour.
Yet there are good reasons to believe China is not heading for the sort of crisis that struck the US in 2008. For one thing, the regulatory clampdown over recent months means debt is no longer expanding so quickly. Indeed, relative to GDP it is no longer expanding at all. What’s more, the composition of debt is changing. Heavily indebted state corporations, which accounted for the bulk of credit growth over the last 10 years, have been pushed to deleverage via debt-to-equity swaps – to the tune of 1 trillion yuan (US$150 billion) over the past 12 months.
In contrast, much of the recent growth in lending has been to households, where debt is rising from a very low base. This is most obvious in mortgage lending. As recently as 2012, just 15 per cent of housing purchases were financed with mortgages. In the first half of this year, the proportion was 60 per cent.
That might sound like a scary increase, yet by the standards of developed economies, Chinese household leverage is modest. China’s ratio of household debt to GDP is currently around 45 per cent. After years of deleveraging, the US ratio is currently 80 per cent, down from 99 per cent at its 2008 pre-crisis height.
Moreover, with incomes rising and interest rates low by historical standards, relatively few Chinese households face problems servicing their debt. As a result, the recent growth in China’s consumer credit looks like the sort of financial deepening that typically accompanies economic development, not the kind of speculative excess that characterised the US sub-prime bubble of the 2000s.
China still faces financial problems. Credit has expanded quickly. Much has been directed into wasteful projects. Some local government investment companies may default. Many smaller banks have lent recklessly, and could face funding problems. And there are definitely asset price bubbles, for example in Shenzhen property.
But for the most part these are localised problems. They do not present systemic risks either to China’s whole financial sector or to its national economy.
So why then has Zhou Xiaochuan broken the cardinal rule of investment banking, and talked immoderately of financial dangers in highly alarmist language?
It’s not hard to guess. Zhou is due to retire early next year, and like any politician – and central banking is a highly political job – he wants to secure his legacy. That means he needs to ensure his successor is on guard against potential dangers that, should they be allowed to blow up over the next few years, could subsequently be blamed on negligent regulation during Zhou’s time on the job. By talking of a possible Minsky moment now, Zhou is effectively dictating that the main policy aim of his successor must be to prevent any such catastrophe in the future.
So the rest of us can breathe slightly more easily. ■
Tom Holland is a former SCMP staffer who has been writing about Asian affairs for more than 20 years