From nicotine to alcohol: China’s continued addiction to credit-intensive growth

Last Friday, China’s GDP data for the first quarter of 2016 was released and it gave financial markets a sign of relief that the world’s second largest economy continues to hum along at a steady pace (at 6.7% y/y) with the tertiary sector continuing to drive growth.


GDP growth by sector

Among the good news was that price levels are starting to recover. For all of 2015, the GDP deflator – the difference between the nominal and real GDP growth rate – was negative, implying that nominal indicators were dragged down because of falling prices, as opposed to falling levels of production. The falling price level infers that revenue- given the same unit of sales- is shrinking and would weaken firms’ ability to meet their interest payments, which are mostly conducted on a fixed basis. As price level recovers, then firms would have an easier time meeting their financial obligations and this reduces the pressure on financial markets as the risk of defaults is reduced. However, the bad news is that despite continued strength in headline GDP, the composition of growth does not appear to be the high quality growth the authorities have been preaching nor is it the type of growth that is sustainable and assists in the process of economic rebalancing in China.

Throughout 2015, much of China’s growth was driven by expansion in financial intermediation, the result of a state-led equity bubble in first half and the exploding bond market due to monetary easing in the second half. The heighted level of activity in capital market increased trading volumes and expanded the balance sheet of the financial services sector. This in turn drove economic activity that propped up GDP growth. As the bond market calms down and the equity markets remain moribund, activity in the financial services sector has returned to the more sane levels seen prior to the equity market bubble. However, as one source of unstable growth dies down another is revived.
Tertiary sector growth by component

construction value added

Real estate has traditionally been the driver of China’s economic growth. Yu Yongding, from the Chinese Academy of Social Sciences, estimates that real-estate accounts for more than 10% of GDP. With growth in the other sectors dragging, executing a list of shovel-ready projects has always been regarded as a reliable source of growth to meet economic growth targets. Indeed, it seems like the Chinese government has not learnt its lesson from the equity-market bubble last year when official media outlets encouraged households to enter into the stock market. In a similar fashion, the Chinese government is pumping up demand to spur a recovery in the real-estate sector to compensate for the lack of real growth in other areas of the economy. In November 2015, the central government relaxed mortgage down payment ratio for first-time home buyers to 25%, down from 30%. With the discretion of local governments, the ratio can be further pushed down to 20%. Combined with five cuts to the required reserve ratio in past 18 months, this created an environment where the quantity and price of loans became more accessible. With the stock market weakening by the second half of 2015, it is natural that Chinese household redirect funds into their most reliable asset class: real-estate. Indeed, since November change to the down payment ratio, nationwide real-estate prices have increased 12% with extreme markets, such as Shenzhen and Shijiazhuang, up 40% in 2015.

national property price index

However, a real-estate led growth isn’t what most had in mind when one thinks of ‘sustainable’ economic growth in China. Real-estate investments are extremely capital intensive and exposes its financier to a very high level of maturity transformation. By promoting real-estate as its latest source of growth, the Chinese government is exposing the financial system to greater financial fragility as short-term funds must be raised to finance this very long term asset. With 700 million square meters of unsold residential floor space in 2015, it begs to wonder why more real-estate needs to be built to satisfy demand that may be high speculative in nature.

By relying on real-estate to support economic growth, the Chinese government has yet to convert or begin to turn to a more sustainable growth model that is not dependent on excess credit generation. Regardless of which index of credit one monitors, one conclusion is clear: the Chinese economy continues to be more indebted and financial fragility continues to build. Many articles have been written on the sustainability of this debt and the many tools the Chinese government has at its disposable to deal with future debt problems – I agree with all these points. However, the more the government delays in addressing issues of overcapacity and unbalanced growth, the more painful it will to be resolve such issues in the background of an aging society and pressing social security needs.

In conclusion, it appears that the Chinese government continues to value short-term economic growth at the cost of financial stability. The authorities continue to use time-proven solutions of fixed asset investment (especially in the real-estate sector) to address short-term macroeconomic deficiency. Despite having been badly burnt in last year’s equity market bubble, the government seems ready to bet again (this time in the real-estate sector) to keep the economy humming. In the short-term, the risks are likely to be limited. However, by ensuring stability in the near term, the government may be risking greater instability in the future.

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