By Logan Wright & Daniel Rosen —
Official Washington opines, with increasing confidence, that China’s economic growth is faltering as a result of the threat of U.S. tariffs. As National Economic Council Director Larry Kudlow puts it, “I’m going to make the case that they are in a weak economic position. That’s not a good place for them to be vis-a-vis the trade negotiations.” The argument follows that Beijing will compromise over long-standing market access and intellectual property-related policy issues out of concern for external vulnerabilities.
The good news is that this is a strategy, and the belief that Trump’s team has no strategy for China whatsoever is incorrect. The bad news is that it’s faulty.
The China-on-the-ropes hypothesis marks a shift from the China narrative of a year ago, in which the Middle Kingdom was presented as an ascendant and politically influential threat to U.S. economic and security interests. Team Trump’s late 2017 National Security Strategy detailed the problems resulting from China “…using economic inducements and penalties, influence operations, and implied military threats to persuade other states to heed its political and security agenda. China’s infrastructure investments and trade strategies reinforce its geopolitical aspirations.” This does not sound like the country Kudlow describes facing a deteriorating economy and a weakening geopolitical bargaining position.
Tariffs announced over the past six months will not change China’s economic risk profile significantly, at least not overnight. China’s potential growth is declining but in slow motion, and Beijing has the ability to lean against this trend through easing monetary policy and accelerating infrastructure investment as long as it is willing to mortgage future growth potential. A decline in exports to the United States will force painful changes in China’s economic structure and drive some firms to bankruptcy, but these developments have already been occurring over the past decade since China passed “peak exports.”
Under the radar of the trade dispute with the United States, however, China’s domestic policy choices have aggravated the set of economic vulnerabilities. The primary source of China’s risk lies in the financial system: it is debt that has delivered the Chinese economic resilience the world has become accustomed to, but that leverage and credit growth are now slowing — sharply.
To make China’s economy double in size since the financial crisis in 2008, the banking system quadrupled, adding $29 trillion in assets in nine years, around one-third of global GDP. An expansion of that size is disproportionate to any conception of gains from Chinese households and corporates’ access to financial services and is, in fact, generating huge risks for them that should be weighed into their worth. Countries with this kind of credit explosion relative to economic size almost always see a financial crisis or a sharp slowdown in growth much quicker than this: China has been the historic exception.
Since 2016, Beijing has rightly tried to reduce risks with an aggressive deleveraging campaign, but by doing so, leaders surfaced dormant risks to stability. China cannot continue growing at close to current or potential rates of GDP growth without a stable, healthy, and still-expanding financial system. The deleveraging campaign is necessary to limit the recent runaway growth of the banking system beyond China’s potential rate of growth; no financial system can grow divorced from the state of its underlying economy for long without accumulating risks. But slowing credit is always a painful process because it means that some borrowers find themselves without financing and are forced to repay debt, usually resulting in lower production or employment levels.
The fundamental sources of stability within China’s financial system have changed in the past five years, and this has created new risks. Before 2012, China’s financial system was large and inefficient but also reasonably stable. It was funded mostly by wholesome bank deposits from households and firms and made loans to staid if plodding state-owned enterprises. Even if those loans generated poor returns, the system kept expanding to cover up bad debt problems. Money flowed into China’s financial system from abroad as the Chinese currency appreciated, so there were no major problems keeping the system funded, growing, and stable.
By 2016 all these pillars of stability were wobbling. The financial system today bears little resemblance to conditions in 2012. New growth after 2012 was not funded by cash deposits but by short-term commercial paper-type instruments known as wealth management products, similar to products seen in the United States ahead of the financial crisis. Loans were made not to state-owned enterprises, but outside the banking system, and as a result, lightly regulated borrowers engaged in riskier activity seeking higher returns. The pressure on China’s currency to weaken also made it more difficult for the central bank to maintain stable funding conditions within China’s financial system. As a result, China’s financial system was creating new sources of risk, while channeling credit to sectors of the economy outside of Beijing’s traditional levers of influence.
The stability of China’s financial system has faced significant threats in the years from 2012 to 2016, but Beijing acted quickly to manage outbreaks of stress. An experiment in June 2013 to squeeze funding conditions and force the banking system to reduce risks temporarily caused the interbank money markets to seize up, forcing the central bank to backtrack and inject liquidity. Shadow banking flourished in China’s bubbly equity market in 2015, causing a dramatic boom-bust cycle and a subsequent government bailout. Other risks when bonds or investment products defaulted were quickly countered with third-party guarantees and other informal support to prevent investors from facing losses and financial risk from spreading.
Increasingly, to maintain the stability of China’s financial system as a whole, Beijing has been forced to extend guarantees and government support to riskier and riskier assets. Because of the widespread expectations of government intervention, it was difficult for investors to ever lose money, and Chinese investors consequently channeled their savings into riskier investments. This increased the risks contained within the system as a whole.
In late 2016, Chinese authorities had seen enough and started to clamp down on the shadow banking system, launching a campaign to reduce financial system risks. In doing so, Beijing severely limited overall credit growth, as shown in Figure 1. Credit growth averaged around 18 percent from 2007 to 2016; now it is closer to 7 percent. This squeeze has particularly hit China’s corporates, creating additional defaults in the corporate bond market and more non-performing loans within the banks. As a result of this slowdown in credit, more defaults within the financial system are inevitable.
Figure 1: Measures of Credit Growth in China, 2007-2018
Analyses explaining China’s past stability focus on economic factors—a high savings rate or the fact that China’s debt is held at home, not abroad. These explanations are insufficient to explain how China’s financial flourish lasted this long and in any case do not provide any assurance that it can be perpetuated much longer. Chinese savings cannot be simply commandeered by authorities for reallocation: while they remain ample, they are already loaned out to state enterprises, for instance, and can’t be moved around without causing equally big problems. Good avenues for policy improvements—like tax reform—are important but years away from implementation. By concentrating credit domestically, China has likely created higher default risks than what would have arisen from a more diverse pool of creditors (including those overseas). Liquidity problems among Chinese financial institutions at home will be no less challenging than external pressures, particularly given the size of the exposures to non-performing assets within domestic financial institutions.
Political explanations for China’s resilience are an essential supplement to the economic factors. Beijing’s credibility in assuring markets of a decisive government response to any financial stress has, in fact, been the crucial underpinning of China’s economic resilience. This credibility has been a powerful asset, but it is not intrinsic to China’s system. In China’s case, credibility has been the byproduct of a track record of successful interventions defending investor interests, and this same credibility will be tested as China reforms its financial system and steps back from widespread guarantees on assets, companies, and banks.
Beijing’s efforts to reduce systemic risks in the long term via the deleveraging campaign are creating new threats to China’s financial stability in the short term. This is part of the necessary pain of financial reform, but it will be difficult to manage in the next few years. There is no nuance involved in cutting credit growth in half, as has happened since 2016. As credit growth slows sharply, Beijing and local authorities will be unable to provide guarantees or prevent defaults in all markets and will have to permit failures. While this is an essential part of financial reform, it could also trigger asset sales and potential panic, as Beijing’s guarantees are called into question. Plausible paths to financial crisis will emerge as Beijing’s credibility to maintain stability changes. The most likely trigger cannot be confidently identified, but the vulnerabilities are legion within such a large and increasingly complex system.
The bottom line is that China’s economic vulnerability is domestic, not a product of external threats. That conclusion suggests a few tweaks to Washington’s current approach to China. First, the Trump administration cannot dictate the dynamics of the U.S.-China relationship today: Beijing’s priorities are squarely at home, not abroad. China is far more likely to respond to domestic stresses—the financial pressure building at the local government level, or any dislocation within the residential property market—rather than to change policy priorities dramatically as a result of external threats. Second, China’s problems will continue to become worse even after this politically charged season of tariff threats, and regardless of Trump’s tenure.
China has a lot more growing to do, and potential growth in China remains higher than in the United States in the decades ahead. That is a reality Washington needs to accept. But this growth will not happen with business-as-usual economic policy in China and continuing to cover up the cracks building within the financial system. That is Beijing’s hard truth. The current brinksmanship, with Washington believing it can force a reckoning, is not the shortcut to changing China’s policy choices. Beijing is already on a dangerous path, and Washington should be better prepared for the risks that can result quickly from the disruptions in China’s financial system, rather than pursuing a strategy based on Beijing suddenly changing course to avert a less pressing threat.
Mr. Logan Wright is an adjunct fellow (non-resident) in the Freeman Chair in China Studies at CSIS and director of China Markets Research at Rhodium Group. Mr. Daniel Rosen is a senior associate (non-resident) with CSIS Freeman Chair in China Studies and founding partner of the Rhodium Group. This commentary is adapted from their jointly authored report of the same name issued by CSIS on October 3, 2018. Read the full report here.