The coming Chinese sneeze
It is an interesting time to take stock of the global economy. It used to be said that when America sneezes, the rest of the world catches cold. The events of last year suggest anything but the same. It is now the case that when America recovers, the rest of the world catches cold. This reversal is due to the fact that good news for the American economy is bad news for global liquidity.
The Federal Reserve strengthens its resolve with each piece of good news to “taper” its unconventional monetary policy. In turn, as treasury yields rise, asset managers retrench from higher-yielding assets towards safe havens.
While the Fed taper is what seems to have been the proximate cause of the recent turbulence, most notably in the emerging markets and their currencies, the growth prospects for the emerging markets less affected by the taper also deserve careful scrutiny. Of these markets, China merits attention. The debt binge in China is beginning to cast a perilous shadow on the health of the global economy. Indeed, one can argue this to be the most significant long-run threat to growth.
In the fall of 2008, global trade appeared to have come to a screeching halt with the collapse of large parts of the financial sector in Western economies. Besides Western economies, such a halt would have been disastrous for an export-driven economy such as China. As regulators in the Western economies put in place rescue packages to heal their financial sectors, the Chinese put in place a massive stimulus programme to keep pushing investment even further in the domestic economy.
State-owned banks have always been an attractive tool worldwide for such stimulus. The Chinese state-owned banks expanded their debt dramatically to fund this stimulus. Why debt? The reason is simple. While shareholders of state-owned banks are by and large wiped out when such banks become distressed, their debt promises are generally fulfilled by the state. In anticipation of these government guarantees, debt financiers do not adequately charge for the risks undertaken by state-owned banks.
The state-owned banks can finance pretty much any project they wish to, or are directed to. As long as no shareholder capital is put at stake, it is a bet in which heads I win, tails the taxpayers lose.
In addition, the deposit rate-ceilings in China prevented bank depositors from demanding higher rates in the first place. Such repression of the households has had two pernicious consequences. One, this lack of market discipline allowed banks to grow their asset bases into highly risky, and now “ghost-town” real-estate and infrastructure investments. Second, the unintended consequence of rate-ceilings has been to create a shadow-banking world in which banks compete for household funds, but outside of the regulated perimeter of banks, and lend to municipalities for infrastructure and real-estate development.
Much like the growth of the money-market funds in the US in response to the Regulation Q that limited bank deposit rates, trust funds and wealth-management products have sprung up in Chinese shadow banking to the tune of over $2 trillion. They offer rates higher than bank deposits with marketing language that has the flavour of investments being safe, akin to the implicit “won’t break the buck” promise of the money-market funds. Further, these shadows touch the feet of the banks.
Trusts are set up by banks themselves and the trust liabilities are perceived to be ultimately those of the sponsoring banks.
Rapid investments of such scale are sustainable only when consumption grows at the same pace. But the Chinese economy has done less well on the latter front and the result has been excess capacity in pretty much all spheres of the Chinese economy. This misallocation of resources is now running its inevitable course. Municipal debts are a question mark, several trusts are unable to meet their promises causing strains on bank liquidity and inter-bank markets, and all this off-balance-sheet mess is putting further strain on banks which are already facing losses on non-performing loans on balance-sheets.
The Chinese stimulus of the past five years has been a big driver of the global rebound from the abyss of fall 2008. As the stimulus subsides and the Chinese government looks for a shift from investment-driven growth to consumption-driven growth, the rest of the world cannot escape a difficult adjustment.
Commodity producers in Australia, Canada and Africa and their currencies will be hit hard. And as bank lending rates rise in China, so will the costs of its exported goods and feed into all other economies.
The Chinese slowdown may be relatively good news for some parts of the deleveraging economy of the US, the less debt-reliant growth engine of India, and perhaps even Japan. It is also a blessing in disguise that much of the Chinese debt is local, ruling out a direct contagion to the other financial sectors. Nevertheless, the slowdown is likely to cast a prolonged shadow on global growth in the years to come. This, rather than the Fed’s taper or Europe’s reluctance to solve its structural problems head on, remains a key risk the world should prepare for.
Viral V. Acharya is C.V. Starr professor of economics, department of finance, New York University Stern School of Business.
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