Earlier posts, here and here, reassessed the risks to the global economy posed by dysfunctional monetary arrangements in Europe and dysfunctional politics in the U.S. The risks emanating from Europe remain; indeed, two years after a near-death experience for the euro prompted a dramatic commitment by ECB President Mario Draghi to "do whatever it takes" to preserve the single currency, growth remains tepid at best, with the European Commission cutting projected Eurozone growth to 1.1 percent in 2015, down from 1.7 percent just six months ago. The situation is brighter in the U.S., where the prospects for growth have improved. Mid-term election results that have put the Republican party firmly in control of Congress may be the precursor for harmful political brinkmanship, but it is possible that the self-interest of politicians looking for re-election may foster compromise.
This post looks at the risks emanating from opaque politics in China.
Two years ago, the concern was that slowing growth, combined with the opaque nature of Chinese politics, could pose a threat to the global economy. Slowing growth reflects the remarkable progress made in absorbing the huge surplus of peasant labour by pursuing a policy of high investment. This process has fuelled growth for two decades. But, as the capital stock increases, and wages begin to rise, the return on incremental investment in export-oriented industries falls. In this environment, the risk that additional investment flows to increasingly speculative investments in housing, for example, cannot be discounted.
Two years on, the expected slowdown is materializing. Rather than the 10 percent growth recorded for much of the past two decades, growth rates in the 6–7 percent range look increasingly like the new normal. But growth at those rates can be expected to slip further over time. Meanwhile, attempts to resist the forces of diminishing marginal productivity by sustaining high rates of investment financed by lightly regulated shadow banks has led some observers to warn of a credit bubble.
To be sure, the signs of excessive expansion are visible across a range of indicators. The ratio of total credit to gross domestic product (GDP), from which credit is serviced, has grown from about 115 percent in 2008 to roughly 175 percent today. Credit growth in the shadow banking system is estimated at 50 percent. Real estate investment is thought to account for roughly 13 percent of GDP, about double the level in the U.S. at the height of the sub-prime boom, while indicators of excess supply spread. And, worryingly, perhaps inevitably, new, exotic investment products are being introduced by shadow banks to keep the credit expansion going. Like the instruments that financed the sub-prime crisis, many of these "highly structured" instruments are opaque and "covenant lite" and offer rates of return higher than the maximum available from regulated banks.
As might be expected given the convergence of slowing growth and leveraged finance, Chinese financial markets have been subjected to a number sharp movements over the past two years, prompting action by regulators and policymakers. The government issued new draft regulations to monitor shadow banks earlier this year. Meanwhile, reformist Premier Li Keqiang launched a national audit of debt taken on by local governments. Presumably, the goal of the audit is to better understand the potential contingent liabilities that the central government faces should local governments be unable to service their debts. At the same time, the highly-visible corruption campaign launched by Li may, in part, be intended to punish local authorities that have authorized unnecessary vanity infrastructure investments or benefited directly from colluding with private developers.
The need to contain excessive credit expansion is driven by the iron law of weighted averages. If the overall growth in the economy is slowing from 10 percent to 7 percent to, eventually, say 3 percent, average investment returns will, over time and on average, also have to decline. This does not imply, of course, that the return on all projects will necessarily fall; there will be investments that generate returns higher than the overall growth rate in the economy. But, if some projects do generate higher returns, other projects would have to generate lower rates of return — including negative returns: the investment boom could turn to an investment crash.
The Chinese authorities have demonstrated considerable adroitness in managing the difficult challenges of transition; they might well avoid a sudden, disruptive financial crisis. But engineering a smooth rebalancing of the economy will require careful management and, arguably, good luck. Against this background is the simple fact that China is no longer a small developing economy that takes prices as given in global markets. It is an economic power in its own right; it is increasingly a price maker (certainly in global commodity markets) and not a price taker. Moreover, because the policies it adopts have effects on the global economy, financial markets look increasingly to Beijing for guidance. This is true of regulatory policy as much as monetary policy, bankruptcy or the rule of law.
In this respect, opaque policy making in response to excessive credit growth could transform the disruptions from a credit crunch into a serious systemic problem with global consequences. Such an outcome would not be helpful for a global economy struggling to recover in the new age of uncertainty.