An emerging credit crunch in China – with banks battening down the hatches amid deteriorating manufacturing conditions and a shrinking current-account surplus – is heightening fears for the outlook of the world’s second-largest economy, with Chinese stocks diving on Monday even as money market rates improve.
Banks have become unwilling to lend to each other in recent weeks, causing a sharp increase in interbank interest rates. Last week, the seven-day repo rate topped 12%, after averaging just 3.3% in the January to May period.
The People’s Bank of China (PBoC) initially gave mixed signals about intervening, even amid pleas from the banks to help free up cash by cutting their reserve requirement ratio – money banks are required to set aside against financial difficulties. The central bank’s initial inaction is telling – highlighting policymakers’ bid to force banks to beef up liquidity management, temper unsustainable credit expansion and address issues in the shadow banking system, say analysts.
The current mini-credit crisis comes amid a four-year effort by Beijing to rein in an expansion of credit of epic proportions, in part the result of its response to the financial crisis. However, the fact that outstanding loans are expected to have reached 200% of GDP at the end of the second quarter, up from 130% in 2008, might have something to do with the central bank’s reluctance to act.
It is not just a case of too much credit, but that much of the lending has gone to fund pumped-up developers, the grandiose plans of local governments, and speculators, without sufficient regard to their ability to repay.
A liquidity crunch makes it harder for businesses to access funding and depresses confidence. Such episodes are not new to China – it has weathered four others since the global financial crisis.
What’s so different about this one? Consecutive purchasing managers’ reports show Chinese manufacturing contracting and prices falling, raising concerns that, with deflationary pressures mounting, China’s days as a dependable growth engine for the world economy might be numbered.
China’s economy grew at 7.7% in the first quarter compared with 7.9% in the fourth quarter of last year. It is expected to have slowed again in the second quarter. The jury is out on how long the current credit crunch will persist, but, at best, the hangover entails a slowing of credit growth, adding to the risks that the economy might cool further this year.
Even a moderate reduction in economic growth could have serious consequences for the rest of the world. The growth rate China needs to maintain for stability, according to economists, is 7.5% GDP growth. That is now in doubt.
Bearish observers say the credit crunch is the early warning sign of a substantial economic correction long overdue.
In a recent note, Lombard Street Research’s China specialist Diana Choyleva writes that bank liquidity stress will continue to mount with real growth weakening but the government’s response indicates it is set on reform, even at the price of slower growth.
However, she warns that given the carnage in the corporate sector, with profits down and the squeeze on margins still on, the economy is in for rising unemployment and a faster build-up of bad loans.
Patrick Chovanec, chief strategist at Silvercrest Asset Management in New York, believes the crunch could lead to a sharp drop in GDP growth because it reflects a serious long-term debt problem which requires ever-more credit expansion to maintain economic growth.
“China has been driving much of GDP growth in the last five years through a credit-fuelled investment boom,” he says. “Investment has compensated for the fall-off in exports and comprises about 50% of GDP.
“As the PBoC has tried to rein in what was initially a lending boom, an increasing portion has shifted into shadow financing, investment instruments and other forms of credit provision. This has persisted such that almost half of new financing is now off-balance sheet.’’
Chovanec says this financing is closely bound-up with the formal banking system, creating an additional stress because it has fuelled a lot of bad investments that are not generating returns.
“You’re not getting your capital back so the only way to finance the next round of projects is through expansion of credit, and that is what has been driving growth year on year,” he says. “But rolling over bad debt at interest eats into credit expansion, so you get less and less GDP growth for the stimulus buck.’’
Chovanec concludes: “The situation has snowballed in the past six months with rapidly declining returns to credit expansion so that even with very high rates of credit expansion, it’s simply not enough to roll over all the bad debt in the system and finance a continued growing investment boom.’’
Others are more sanguine. Says Chris Williamson, chief economist at Markit: “The latest data show the slowdown in global trade hitting China. Exports fell at the fastest rate since September 2009, the height of the big global credit squeeze.
“With this environment occurring alongside a squeeze of domestic credit, the prospects are looking quite dire for China, suggesting there’s some need for a further stimulus there.”
He adds: “We’re more used to double-digit growth which was sufficient to drive an expansion of the global economy along the trend rates we saw prior to the crisis.
“Two-and-a-half points per year of slower growth in China does have an effect elsewhere – weaker demand for capital equipment plus, of course, there’s slower pace of expansion in consumer spending and the development of those markets and how that affects western firms’ projections.
“This calls into question whether all the projections of how rapidly China was going to be growing were really realistic. Maybe walls are being hit in terms of China’s growth that suggest a lot of people are being overly optimistic.’’
Williamson says if growth does slip below 7.7% in Q2, the government will seek ways increase bank lending but warns it will not solve the issue of a lack of viable projects to invest the money in.
He concludes: “It’s all pointing to 2013 being an especially weak year of growth for China, possibly dropping below 7.5%, adding to the sense that those double-digit growth figures are well and truly behind us.’’
And that’s at the bullish end of projections.
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