Investors sighed with relief when Chinese government officials reported that China’s economy grew by 6.7% in the first quarter of 2016 compared to a year ago. Conveniently, this published growth number is in line with the government’s target of growth no lower than 6.5% and no higher than 7%, as announced during this year’s annual session of the National People’s Congress. The IMF followed suit, upgrading its growth forecast for 2016 by 0.2% to 6.5%.
However, targeting such a high growth number comes at a cost. As so often in the past, China will use both fiscal and monetary policies to hit the target. The fiscal deficit for this year is budgeted at 3%, whereas credit growth (M2) will be 13%. Although the government wants to rebalance the economy from an investment-driven industrial economy to a consumption-driven services one, there yet is little proof of this happening. Yes, Li Keqiang, China’s prime minister, told his party’s Congress that he would reduce overcapacity in certain industrial segments, like steel making and coal mining, but we have not seen detailed plans on how this will be implemented.
Meanwhile, private debt is increasing by a rate double China’s economic growth. In March alone, lending reached a stratospheric USD 360 billion and much of this money is allocated badly, i.e. to companies that may not be able to repay the debts. Indeed, the governor of the People’s Bank of China went so far to call the ratio of lending to gross domestic product excessive. Given China’s capital controls and poor investment alternatives, a lot of money ends up in the housing sector. This has led to a property bubble, especially in China’s largest cities (Beijing, Guangzhou, Shanghai and Shenzhen) where house prices have gone haywire (in Shenzhen by 50% in 2015), and to oversupply, especially in second- and third-tier cities.
By not enacting structural reforms, the Chinese leaders will only delay the day of reckoning, risking a nasty hard landing. First step, in our view, is to write down bad debts that now routinely are rolled over by China’s public banks. This may entail a capital injection of 10-15% to keep these banks solvent. Inefficient (state-owned) enterprises in industries that experience massive overcapacity should be allowed to go under. As a steel welder may not necessarily be a good barista in a swanky coffee bar, the government should provide a safety net for those workers that become unemployed. Finally, the government should speed up liberalization of financial markets so that better investment decisions are made in the future. These policy elements are all well known and actually underwritten by China’s government. Now it is time to act and slay the dragon.
