WHY TIME IS RUNNING OUT FOR CHINA’S DEBT-DRIVEN BOOM

There is now no denying that China’s economy is slowing sharply, though this can be masked by mini-booms along the way.

China is creating credit at twice the pace of underlying growth and is relying on hazardous bubbles to keep growth running far above the safe speed limit, Fitch Ratings has warned.

Short-term stimulus is papering over deep cracks in the economy and vital reforms are being neglected, storing up serious trouble for the future.

The Fitch credit agency said state control over the banking system will prevent a sudden collapse in confidence or a western-style financial crash, but the Communist authorities are running out of tools to meet their inflated GDP targets.

China’s epic catch-up boom since the early 1980s will likely sputter out this year as banks struggle with the legacy of bad debts and chronic malinvestment.

One basic bottom line: President Xi Jinping talks a good game on reform but in reality relies on credit stimulus. He cannot keep pulling rabbits out of a hat.

The denouement may resemble Japan’s return to earth in the 1990s after seeming to defy gravity,  but in China’s case on a much larger scale. Estimates vary but the global ramifications could be five times as great as the Japanese episode.

“Fitch’s base case remains that China’s large debt burden will translate into substantially slower economic growth by the end of the decade rather than an outright financial crisis,” says Andrew Fennell, the agency’s director in Asia.

“Short-term growth targets have been prioritized over some areas of structural reform, particularly efforts to reduce the economy’s dependence on credit-intensive investment. Policy stimulus has succeeded in maintaining growth within the official target range, but it has come at the cost of a further build-up in leverage,” he told me.

Fitch says all forms of credit – including local government bond issuance – grew at annual rate 16.1% last year while nominal GDP expanded at just at 8%. “The rapid increase in credit required to keep GDP growing at its current rate strongly suggests that a sustainable rate of medium-term economic growth is well below the authorities’ prevalent targets.”

Wei Yao from Societe Generale said total non-financial debt is approaching 270% of GDP – up from 250% at end-2015 – and is on track to hit 300% within three years unless the Politiburo abandons its “arbitrary” targets.

In fact, as you can see, China’s Total Debt-to-GDP was almost at 300% in the first quarter of last year, and has surely shot past that by now:

China Total Debt to GDP as of Q1 2016

The country has tangled itself in knots and faces its own version of the ‘Impossible Trinity’:

“While this does not make a debt crisis a near-term certainty, it is likely to be increasingly difficult for Chinese policymakers to uphold growth levels, financial stability with a steady balance of payments, and controls over yuan all at the same time,” says Ms. Yao.

There is no longer any compelling reason to stick to these foolish political targets given that the country already faces a demographic crunch. It has passed the ‘Lewis Point’  in its economic development, and is running short of cheap labor from the countryside.

Capital Economics says the ratio of job openings to job seekers – the neuralgic issue for the Communist Party – is near record levels at over 1.1. China created a paltry 13 million net jobs in the cities last year – that out of a total workforce of over 900 million..

Fitch said capital outflows this year would continue to drain foreign exchange reserves – already down by $1 trillion – but “are unlikely to occur at a pace that proves systemically threatening”. Even more draconian curbs will be used if need be.

The credit agency said the latest burst of lending has “resulted in a surge in home prices and appears to have fueled asset bubbles.” Beijing has since had to slam on the brakes, choking off the boom in the larger cities. The official property index for December showed that prices now falling in 20 of the 70 cities followed.

The boom was not accidental. The government actively pushed buyers into the real estate market last year – much as it deliberately stoked a stock market frenzy in 2015, only to regret it later.

It remains to be seen whether Beijing will allow a housing shake-out or whether it will instead resorts to another round of debt-creation in a stop-go process of increasingly corrosive boomlets.

“Evidence to date suggests local governments’ incentives to sustain prices at artificially high levels far outweigh their desire to allow market forces to work. They will probably step in again should house prices start to fall significantly,” say consultants Fathom.

China’s economic trajectory over the last two years has been widely misunderstood in the West. The economy went into an unacknowledged recession in early 2015 due to the combined squeeze of monetary tightening and a fiscal shock, taking global commodity prices down with it. The slump hit bottom eighteen months ago.

Beijing lost its nerve and let rip with a fiscal stimulus comparable in intensity to the post-Lehman blitz in 2009, encouraging a boom that is now near its peak and is completely unsustainable. The augmented budget deficit reached 11.8% of GDP at the end of last year.

The Politburo is once again having to lower the dosage. JP Morgan estimates that the growth rate of infrastructure investment plummeted in December to 5.7% from 14.7% the month before.

Yang Zhao from Nomura said the boom will peter out this year. “We expect the drag on growth to become more evident. December data were all weaker than we expected,” he said.

Analysts think there is still enough juice in the system to keep Chinese growth humming through the first quarter of this year but it will be obvious by the Spring that the latest mini-cycle is losing momentum.

The only question is whether China tries to pull yet another rabbit out of the hat or finally gives up the unhealthy quest for perpetual uber-growth.

Ambrose Evans-Pritchard is the International Business Editor of the London Telegraph.