This is an excerpt of the March 2014 Longbrake Letter. To read the letter in its entirety, click here.
In recent days, Chinese data reports for industrial output, investment, and retail sales have systematically fallen short of investor expectations. Although this follows a pattern that has occurred at the beginning of the calendar year in each of the last three years, it is receiving more concern this year because of concern about tight credit and potential financial stress. This growing concern is reflected in the poor performance of the China Shanghai Composite stock index, which has fallen over 35 percent over the last three years.
For a variety of reasons, a financial crisis is not imminent in China. But serious imbalances in the Chinese economy have been building for years and, if the policies that have been responsible are not adjusted, the imbalances will continue to build and could lead eventually to a severe financial crisis. That is because resources are being allocated increasingly to investment activities that have low or negative rates of return. The investments are being financed by credit that ultimately cannot be repaid in full because the investments are not earning sufficient returns to service both interest costs and repay principal. Put differently, the rate of return on investment is less than the cost of capital. This state of affairs can be sustained for a while through refinancing loans and capitalizing interest expenses, but eventually losses will have to be realized and bankruptcies will occur. Thus, sometime in China’s future a financial cataclysm – a Minsky moment – lurks unless policies are pursued that reverse the persistent misallocation of resources in non-economic activities.
As a reminder, Minsky moments occur when markets realize that significant amounts of credit cannot be repaid through cash flows naturally flowing from the business activities they finance. Credit extension increasing covers losses in addition to new investment initiatives. This is a pattern consistent with financial speculative bubbles. When markets realize that loans will never be repaid in full, credit access is abruptly withdrawn and the Minsky moment is underway. Governments then are forced to intervene and absorb the losses to prevent economic collapse. This is what happened in the U.S., Europe, and elsewhere in the world during the financial panic of 2007-08. But, while governments can stop panic, the harm done to economies is severe and, as we have seen, recoveries are slow and extended. And, there is also a limit to how much bad debt a government can absorb before it has its own Minsky moment. Greece is a recent case in point but there are many other examples throughout history.
There are two data points that underline the evolving credit speculative bubble. The first has to do with deteriorating return on assets (ROA) and return on equity (ROE) in state-owned enterprises (SOEs). According to data from the Ministry of Finance, ROA for nonfinancial SOEs declined from a peak of 5.0 percent in 2007 to 3.25 percent in 2011. The decline was broad-based across a variety of industries. Other data indicate that the ROA for non-state companies was approximately 8.0 percent in 2007 and 9.0 percent recently.¹
The second set of data has to do with the rate of growth in credit compared to the rate of growth in nominal GDP. When credit grows faster than GDP, which is what has been happening in China, this indicates that a portion of credit is going to support price increases in existing assets, to refinance existing debt and capitalize interest, or to finance unproductive investments. This is reflective of speculation or, in Minsky terminology, Ponzi finance. But the situation is deteriorating because the gap between the rates at which credit and nominal GDP have been growing has been widening. This means that an increasing portion of credit growth is going in speculative ventures and nonproductive investments. These are the indicia of inflating bubbles.
There is hope that China’s new leadership and the reforms announced at the culmination of the Third Plenum last November will diminish the extent of existing imbalances and set China on a course of sustainable growth. However, to date many of the reforms are couched as goals and have yet to be articulated through specific implementation plans. The absence of specifics for dealing with misallocation of resources and underperformance of SOEs is especially troublesome. Also, the leadership is clinging to a real GDP growth goal of 7.5 percent for the next several years, which can only be met in the short run by continuing to pursue the policies that are contributing to growing, but ultimately unsustainable, imbalances.
To avoid a potentially painful and stressful future, China needs to implement reforms with teeth and accept the reality that a healthy and stable economy will be one that grows more slowly than 7.5 percent.
¹Data provided by Gavekal Dragonomics.