Primavera Capital's Fred Hu and AGI Advisory Board Co-Chair Michael Spence lay out their concerns over China's economy.
Describe the situation that has led to the downgrade?
While China’s cumulative financial reforms since the late 1990s have largely addressed the massive legacy problems of non-performing loans and significantly improved the health of the country’s financial system, China’s financial system continues to be imbedded with major vulnerabilities. As the Chinese economy slows down naturally at this stage of growth, its financial vulnerabilities have increased substantially.
Can you name some of these vulnerabilities?
There is continued state intervention which magnifies the pro-cyclical interactions between finance and macroeconomic fluctuations, and undermines the prudent management of financial institutions. The state also continues to exert substantial political influence over the operations of these financial institutions. Government-directed lending led to the credit boom which contributed to housing bubbles, overinvestment in a range of manufacturing industries and inefficient or wasteful government infrastructure projects. While bank credit expanded at an average rate of 18 per cent between 2007-2014, non-bank or shadow bank lending grew twice as fast. This credit boom has made China one of the most heavily leveraged economies in the world.
Aside from this, China has also seen increased market market volatility resulting from ongoing financial liberalization. The past five years have seen a rapid expansion of non-bank financing activities in the form of trust loans, wealth management products (WMPs), and alternative investment vehicles sold to the general public. Non-bank or shadow banking has also hit an estimated 15 per cent of total domestic credit. While some of this has funded deserving SMEs, the bulk flows to troubled real estate companies, local government financing vehicles and speculative bets in the stock market.
These and other factors have caused China to emerge as one of the major headline risks in the current highly turbulent global environment. There are strong bearish sentiments towards China’s GDP growth in general and the health of the Chinese financial system in particular.
Is this a ticking time bomb situation?
While the probability of a full-blown financial crisis in China remains relatively small at this point, the Chinese leadership should be fully cognizant of the emerging risks and vulnerabilities, and take strong actions to contain the risks and strengthen the financial system.
What kind of policy responses can we hope to see?
The immediate and most potent policy response is to carefully and skillfully manage China’s ongoing economic transition. A hard-landing of the real economy would have an adverse impact on financial stability, with rising corporate defaults and snowballing nonperforming loans endangering the health of the banks, which will cause in turn a sharp tightening of credit conditions, and at its worst, bank failures, a severe credit crunch and rising risks of recessions. Indeed global investor anxieties about China’s banking sector, the stock market, and the yuan exchange rate can all ultimately be traced to the concerns about the state of the Chinese economy.
We must remember that China’s economy is currently in a bumpy and uncertain deceleration. Manufacturing overcapacity, persistent weakness in exports, excess housing inventories and high levels of debt in the corporate and local government sectors together pose daunting difficulties to maintaining macroeconomic and financial stability in the short and medium terms.