China’s Growth Deteriorates, Leading to Increased Debt for Diminished Returns – By Reuters

By Elias Glenn

BEIJING – China’s economy is experiencing another quarter of steady growth, but the rate of credit creation is becoming increasingly frantic for every additional unit of production. Inefficient state-owned enterprises are absorbing a greater portion of lending.

In the first half of the year, the world’s second-largest economy grew by 6.7 percent, unchanged from the previous quarter. This indicates policymakers’ commitment to managing the pace of slowing growth following 25 years of rapid expansion.

However, analysts warn that this commitment has led to a concerning rise in debt, which is now significantly less effective at generating growth compared to previous years. Ruchir Sharma, head of emerging markets at Morgan Stanley, stated that the amount of debt accumulated in China over the last five to seven years is unprecedented. No developing country has ever taken on such a large amount of debt on a marginal basis.

While the Chinese government may find relief in loose monetary policies and increased deficit spending that prevent a deeper economic downturn, the diminishing returns on such stimulus, along with a rise in defaults and non-performing loans, create what Sharma refers to as a "fertile ground for some accident to happen."

From 2003 to 2008, when annual growth averaged over 11 percent, it took just one yuan of additional credit to generate one yuan of GDP growth. This ratio increased to two for one during 2009-2010, following a massive stimulus program in response to the global financial crisis. Currently, it requires six yuan of credit to produce one yuan of growth, a figure that exceeds even the debt levels seen in the United States during the housing bubble that precipitated the global crisis.

China’s total bond debt has risen by over 50 percent in the past 18 months, reaching 57 trillion yuan, which is approximately 80 percent of its GDP. The total social financing figure, a broad measure of credit, rose by 10.9 percent in the first half of the year, totaling 9.75 trillion yuan.

China’s money supply has surged alongside new lending. It now stands at 149 trillion yuan, 73 percent higher than that of the United States, despite the U.S. economy being about 60 percent larger. Kevin Smith, CEO of Crescat Capital, remarked that China is effectively the largest money printer globally and that the balance is quite extreme.

The poor returns from China’s monetary expansion are largely due to state firms being the primary recipients of new credit, to the detriment of the more efficient private sector. Although some private sector slowdown can be attributed to low business confidence, a lack of access to affordable financing is also significant, as banks frequently opt for the security of state-owned borrowers. Estimates indicate that private firms are paying 6 percentage points more in interest for bank loans compared to their state-owned counterparts.

While Beijing’s official stance is to transition the economy toward the private sector and reduce surplus capacity in inefficient heavy industries, this goal is often subordinated to the immediate objective of achieving growth targets.

Policymakers suggest that although corporate debt levels are high, the central government has the capacity to increase its debt ratios and fiscal deficit to stimulate the economy further. Analysts anticipate further monetary easing, including interest rate cuts, which may lead to more borrowing and additional bad debts.

Fathom Consulting analyst Laura Eaton cautioned that China’s focus on short-term gains will exacerbate its longstanding issues with excess capacity and non-performing loans. Smith from Crescat Capital forecasts the possibility of a dual currency and banking crisis, predicting a 20 percent devaluation of the yuan against the dollar.

“It’s a question of when, and it looks like it’s coming pretty close,” he warned.