For the first two years of the global financial crisis, America was front and centre of market concerns as first the housing market collapsed and then the likes of Bear Stearns, Lehman Brothers, Merrill Lynch, AIG and other financial behemoths either fell over completely or were gobbled up by competitors. Over the past two years, Europe’s financial travails have been the principal pre-occupation of investors and traders alike, and they continue to cast a long shadow over the rest of the planet. However, the baton for the major source of systemic risk is now being passed to China. This arguably represents the most frightening phase of all.
Notwithstanding the hugely opaque statistics emanating from the world’s second largest economy, it is abundantly clear that the pace of growth in China slowed much more rapidly than expected in the first half of this year. All through this period, various purchasing managers’ surveys registered readings at or below 50, suggesting that output growth is contracting. Demand in some key sectors such as coal, steel and ship-building has collapsed. At the same time, electricity production rose by just 0.7% YoY in April (latest available figures), with May likely to show a decline. Home sales have slowed appreciably this year; loan demand has waned markedly; and both residential and commercial construction, which at the height of the economic boom represented more than 10% of GDP, has completely stalled. If the economy really was growing at 10% through 2010-2011, then the underlying pace of growth may already be nearer 6%.
China’s policy machine now confronts a multitude of financial issues. In the first instance, such has been the explosion in loan growth over recent years that most sectors of the economy are now suffering from an excess of debt accumulation. In the property sector, thousands of developers who took on enormous debts over recent years are now being forced to flood the market with properties and land at much cheaper prices. In response to the 2008 GFC, China essentially permitted the banks to undertake almost unlimited lending; in effect, property developers gorged themselves senseless on debt in their rush to acquire land and real estate. Most Chinese banks are now faced with rapidly rising levels of non-performing loans. At the same time as this loan-rush was unfolding, local governments were likewise borrowing from state-owned banks with gay abandon; these funds were then generally invested in infrastructure. One respected commentator in China claims that the debt of these local government funding vehicles alone could represent as much as 50% of GDP.
With the real-estate and investment boom now ended, an abundance of excess capacity has emerged which is exerting considerable deflationary force onto the local economy. Prices for numerous industrial products are declining – producer prices are down significantly for the third time in a decade and this invariably results in downward pressure on global inflation. The price of food, which represents one-third of the consumption basket in China, is also decreasing, as is the regulated price of fuel. Also, house and land prices are still falling in most of the major cities.
As illustrated by the accelerated re-calibration of policy settings recently, Beijing is clearly rattled by how rapidly the pace of recovery has subsided. Moreover, it would be remarkable if policy-makers could steady the listing ship, despite the multitude of policy options at their disposal. In effect, the economy is taking on a lot of water, and policy officials will not be able to prevent the holes in the hull from getting larger. Just as in many advanced economies, China is in the midst of a cathartic process of balance sheet deleveraging and debt deflation which will take many years to rebalance. As many central banks and governments are discovering around the world, both monetary and fiscal policy are rendered virtually helpless while this adjustment occurs.
China’s financial demise is set to become a dominant theme in global asset markets.