By Paolo von Schirach
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September 3, 2013
WASHINGTON – I pointed out in a recent piece how China’s still impressive 7.5% rate of growth hides a large amount of poor investment choices that led to high levels of bad debt and insolvent corporations kept alive only by more easy credit provided by state-owned banks (see link above to related piece). Left unchecked, over time this system of easy money to undeserving borrowers leads to a fate quite similar to what befell on Greece: insolvency.
Political loans
Of course China, with its enormous cash reserves and still relatively low levels of debt, is not even near a Greece-like scenario. But some of the dangerous dynamics, such as “political loans” to inefficient state-owned corporations made by complacent state-owned banks are quite similar. Over time no economy can survive, let alone thrive, if a growing percentage of its “investments” turn into bad loans.
But how can Chinese banks afford to dole out all this cash? Professor Michael Pettis, Finance Professor at Peking University, provides a very clear explanation in an excellent op-ed piece in The Financial Times (China has a choice – short-term growth or sustainability, September 3, 2013). Quite simply, Chinese state banks can provide extremely easy credit simply because they give almost nothing to depositors.
Mountains of free cash
Essentially, all the Chinese state-owned banks get plenty of cash at almost zero cost from hundreds of millions of depositors who have no other choice. And so they can afford to lend it at extremely favorable rates. And here it gets tricky. In a “normal” market driven environment it would be smart to lend cheap money only to promising enterprises.
But China, whatever its new capitalistic inclinations, is not yet a market economy. And therefore lending decisions are largely political. If the political imperative is “growth”, so that the leadership can show impressive economic ascendance, year after year, then the implicit instruction is to get the money out the door as quickly as possible, so that it will finance any and all projects, good and bad.
Money to friends
It is not very difficult to understand that in this context featuring a “guided economy” largely driven by political, as opposed to economic, priorities a lot if not most of the cash will go to the well connected, as opposed to the most deserving. And this is pretty much what happened.
Hence gigantic, but mostly empty shopping malls dotting China, brand new model cities with no people, way too many luxury apartments built only as investments for speculators, along with factories and steel mills operating way below capacity because of over supply of almost anything. But, thanks to more credit, hardly anybody goes bankrupt in China. And state owned enterprises are totally protected.
Higher interest rates?
Given this dangerous trend, argues Professor Pettis, it is somewhat encouraging that the Chinese monetary authorities began to phase out this perverse incentive that results in the financing of too many unproductive ventures. Indeed, real interest rates have moved higher, even though in the near term this policy clearly hurts growth.
But Pettis argues that the test is right now. As the Chinese economy is confronted with even slower growth, the temptation is very strong to revive economic activities by cutting interest rates, this way boosting investments. However, the smart thing would be to keep interest rates high, this way making credit more difficult. Tighter credit would favor the most efficient borrowers, while the others would not survive.
Furthermore, by pursuing this higher interests rates policy, the Chinese authorities would tilt the financial balance in favor of consumers. Indeed, ordinary people would get a higher return on their deposits. The flip side, of course, is that the overall economy would suffer. Without the artificial booster of more easy credit, most likely many weak companies would go under, and many more would be unable to increase production. This would inevitably result in slower growth, further deflating the already questionable myth of an endless Chinese economic miracle.
More balanced economy; but slower growth
The stakes are very high. As Professor Pettis writes, it will be extremely interesting to see which way the Chinese Government will go: less credit so that only worthy enterprises will survive, or easy money so that this dangerous party will keep going?
I suspect that in the end politics will trump good economic stewardship. Even an illiberal government needs broad-based political support. Beijing is likely to opt for relaxed credit, simply because this will keep more people employed , avoid social unease, and it will buy time.