Argument

Red Herring

The smart money wants China to slow its overheated economy. So why is everyone so freaked out?

For much of the past two decades, China's economic surge has been viewed with intense skepticism in the financial world and with substantial distrust in foreign-policy land. Yet at every turn, China has defied skeptics and continued to expand, albeit at a slightly slower pace than the near double-digit growth rates seen over the past decade. In fact, for some time, many observers -- as well as the government in Beijing -- believed that China's growth was a bit too strong. Yet the recent market blip has now just added to the widely held conviction that China's economic emergence is a chimera built on rotten foundations of too much real estate, too much credit, and too much government spending on infrastructure.

Last week, latent concerns erupted into a sudden surge of panic that the Chinese economic miracle is about to crash. China's stock market plunged to lows not seen since the heart of the financial crisis in 2009. More ominous, global markets reacted as well, taking seriously -- and not at all in stride -- the possibility that this time an implosion is imminent.

Before dealing with the specifics of the past week, let's stipulate the following: China has defied expectations because it has found, until now, a functional economic and political formula -- whether or not we like that formula. Moreover, despite some minor disputes over islands with Japan and the Philippines, its leadership has avoided drastic foreign-policy missteps that might endanger its domestic economic trajectory. That has been the case at each point of crisis over the past 20 years, and it is likely to be the case now as well.

There were two proximate causes of the recent panic. One, lending rates between Chinese banks soared to alarmingly high levels after China's central bank, the People's Bank of China, made murmurings that credit has gotten out of hand and needs to be curtailed. Second, an evaluation of China's credit system by a Fitch Ratings analyst named Charlene Chu noted that Beijing's official figures mask the vast expansion of shadow banking and credit in China and that the level has now reached a critical point. That followed on the heels of Fitch downgrading China's credit rating.

You may recall what happened almost exactly two years ago when Standard & Poor's (S&P) downgraded the U.S. credit rating: markets plunged, Washington politics turned even more nasty and partisan, and global players jumped on an "I told you so" bandwagon questioning the integrity of the American political system.

In many ways, this week's China plunge -- with its attendant global ripples -- is the same story, except this time it was Fitch rather than S&P. Chu delivered a devastating critique of the Chinese financial system, and by adding up not just official credit outstanding but off-balance-sheet transactions and a host of other less obvious metrics, she came up with a figure of $23 trillion of debt, compared with only $9 trillion four years ago. That also raised the ratio of overall debt, adding up government, companies, and individuals, to nearly 200 percent of China's GDP. The preponderance of that debt is China's corporate debt, much of it funneled through local governments and their banks to state-owned corporations.

According to Chu, the conclusion is obvious: "The credit-driven growth model is clearly falling apart. This could feed into a massive overcapacity problem and potentially into a Japanese-style deflation," she said in an interview with the Daily Telegraph. "There is no transparency in the shadow banking system, and systemic risk is rising."

The only way to describe the reaction to Chu's report is with a cliché: like a match on a tinderbox. Her report coincided with the lack of action taken by the People's Bank of China to ease the interbank credit crunch, and added to that combustible mix was the elliptical language used by U.S. Federal Reserve Chairman Ben Bernanke to suggest that the Fed might soon slow or even halt its $85 billion of bond purchases each month. And voilà, a financial perfect storm. Equities globally plunged 5 to 10 percent. Even more startling was the sharp rise in bond prices, especially in emerging markets that are seen as exposed to China.

At the time of the S&P's downgrade of U.S. credit in 2011, I asked how it happened that we had given so much power to a few analysts at a private financial enterprise. Back then it was a man named David Beers who headed the team that downgraded the United States. This time it is Charlene Chu. Both of them may be brilliant, acute -- and even correct. But it is absurd that their views carry such weight and that financial markets and the media behave like lemmings in according those opinions such respect.

China has indeed seen a substantial expansion of credit, much of it mandated by Beijing and local governments in the wake of the 2008-2009 global financial crisis. Because that credit is funneled through state-owned companies, it shows up as corporate debt rather than sovereign. This is why China has looked better on such metrics as government debt-to-GDP, a ratio so beloved by markets in the past few years. But China has done its own version of Keynesian economics, or government priming of the pump, to keep its economic growth engine humming along.

The new government of President Xi Jinping and his premier, Li Keqiang, however, appears determined to wean the Chinese economy off of easy credit and government stimulus as surely as Bernanke does in the United States. There is, of course, a world of difference between wanting to do that and being willing to accept the possible negative consequences of doing that. In the past few days, both Chinese officials and U.S. central bankers have attempted to calm markets by saying, in effect, "Don't worry; we want to reduce easy money, but we're not about to do it quite yet." Still, the seeds are being sown.

More to the point, in China -- as one friend who sits at the nexus of finance and government in Beijing told me -- Xi and Li are convinced that only a domestic economy built on a foundation of a vibrant middle class can thrive long term. Government infrastructure and housing projects cannot be the foundation, however successful those were in getting China to where it now stands.

You can read this situation in multiple ways. Chu's market-moving analysis is one way: that China is just a credit-sustained house of cards. Danger lies ahead. But another perspective is that Beijing's moves belie a deeper stability: that only because there is now an increasingly robust Chinese economy -- with a middle class in the hundreds of millions -- can the government insist on curtailing credit and speculation, whether in housing or financial assets.

That perspective deserves far more attention. Instead, this toxic brew of animosity about China's rise, pique at the sheltering of Edward Snowden, and frisson of schadenfreude at seeing Beijing's economic model hit a wall (thus demonstrating the superiority of American free market capitalism) makes the lions, and tigers, and bears argument much more convincing. The belief that China must follow the same downward pattern as other once-hot infrastructure- and export-led economies such as Japan also clouds perspectives. Those economies slowed precipitously, goes the argument, and so therefore must China.

Undoubtedly, China's economic growth rate will slow as the country becomes larger and more affluent, just as the United States did. But a China growing at 5 or 6 percent annually (if it even slows that much), fueled by domestic demand, is still a massive growth story: Hundreds of millions of people will enhance their material lives in basic ways and create market opportunities globally. A China growing at that rate organically is still the greatest economic success story in human history.

That is the direction China is heading, away from speculation and corruption and toward that organic domestic growth. Of course, it may not get there. Who knows? But nor can we so easily dismiss the potential that it will make that transition, especially given that it has confounded expectations routinely over the past 20 years. Rather than freaking out, financial markets would be wiser to see the shifts in China as unequivocally positive -- especially if Xi maintains his resolve in the face of significant domestic pressure to maintain previous policies, and in the face of tetchy global markets. But financial markets have exhibited a dearth of wisdom of late.

China remains a pivot of the global economy, and its stability and success are vital to prosperity across the world. Moreover, its economic success is central to its own stability, to how it behaves as an emergent military power, and to how it engages the world politically and diplomatically. A China in crisis will produce a Brazil in crisis, a sub-Saharan Africa in crisis, an East Asia in crisis, and likely a United States in crisis. That is to no one's benefit. The simultaneity of China's credit contraction and Bernanke's hints was greeted as a negative, but there are instead positive signs that organic economic activity in both countries is stable and accelerating sufficiently. The S&P was wrong about the United States in 2011, and Fitch will likely be wrong about China in 2013.

PHILIPPE LOPEZ/AFP/Getty Images

Argument

Crunch Time

Why low growth is China's new normal.

In the months leading up to last week's liquidity crunch, in which the cost of short-term loans in China spiked and roiled global markets, most financial institutions had been lowering their growth forecasts for China. In mid-June, the World Bank revised its 2013 Chinese growth forecast from 8.4 percent to 7.7 percent; HSBC, Credit Suisse, and Goldman Sachs, among others, have also downgraded their Chinese growth forecasts several times over the last two years, as quarterly data have kept revealing lower-than-expected economic growth and higher-than-expected credit growth. Many banks now estimate around 7 percent to be the new normal.

But the banks' numbers are likely still too high. China's economy is at a turning point in its transformation from one driven by export and investment to one driven more by domestic household spending. Growth predictions are underestimating the impact of this shift.

The recent liquidity crunch, and its cause, illustrates some of the difficulties China's economy will face in the future. Over the last two years, and especially in 2013, mainland corporations with offshore affiliates had been borrowing money abroad, faking trade invoices to import the money disguised as export revenues, and profitably relending it as Chinese yuan. As China receives more dollars from exports and foreign investment than it spends on imports and Chinese investment abroad, the People's Bank of China, the central bank, is forced to buy those excess dollars to maintain the value of the yuan. It does this by borrowing yuan in the domestic markets. But because its borrowing cost is greater than the return it receives when it invests those dollars in low-earning U.S. Treasury bonds, the central bank loses money as its reserves expand. Large companies bringing money into the mainland also force the central bank to expand the domestic money supply when it purchases the inflows, expanding the amount of credit in the system.

In May, however, the authorities began clamping down on the fake trade invoices, causing export revenues to decline. Foreign currency inflows into China dried up, as did the liquidity that had accommodated rapid credit growth. The combination of rapidly rising credit and slower growth in the money supply created enormous liquidity strains within the banking system. This is probably what caused last week's liquidity crunch and this week's market convulsions.

The surprising thing about this process has been the government's determination to see it through. Policymakers in Beijing have not backed down from the implications of rebalancing China's economy away from its addiction to investment and debt, even though economic growth is slowing and banks are pleading with the government to turn back on the liquidity spigots. Whereas the administration of President Xi Jinping's predecessor, Hu Jintao, never allowed growth to slow much before losing its nerve and increasing credit, Xi seems determined to stay the course.

There are two important lessons to be drawn from last week's panic. First, the central bank and the leadership in Beijing seem determined to try to get their arms around credit expansion -- even if that means, as it absolutely must, that growth will suffer and the banks will come under pressure. The extent of the freezing of the money markets on June 20 surprised many, including probably the central bank itself, but there will likely be more disruption in the markets over the next few years as Beijing tries to control what has become a runaway process.

Second, reining in credit won't be easy: the financial system and a whole host of borrowers -- including real estate developers, capital-intensive manufacturers, and local and municipal governments -- are too addicted to rapid credit expansion. Attempts to constrain credit growth will create significant strains in the financial sector, as borrowers find it hard to roll over debt that they cannot otherwise repay. Constraining credit growth will also mean a significant reduction in economic activity over the next decade.

Last week is a reminder that Beijing is playing a difficult game. The rest of the world should try to understand the stakes, and accommodate China's transition to a more sustainable growth model. As policymakers in China continue to try to restructure the economy away from reliance on massive, debt-fueling investment projects that create little value for the economy, the United States, Europe, and Japan must implement policies that reduce trade pressures. Any additional adverse trade conditions will further jeopardize the stability of China's economy, especially as lower trade surpluses and decreased foreign investment slow money creation by China's central bank. A trade war would clearly be devastating for Beijing's attempt to rebalance its economy and have potentially critical implications for global markets.

Regardless of what happens next, the consensus expectations that China's economy will grow at roughly 7 percent over the next few years can be safely ignored. Growth driven by consumption, instead of trade and investment, is alone sufficient to grow China's GDP by 3 to 4 percent annually. But it is not clear that consumption can be sustained if investment growth levels are sharply reduced. If Beijing can successfully manage the employment consequences of decreased investment growth, perhaps it can keep consumption growing at current levels. But that's a tricky proposition.

It's likely that the days of the super-powered Chinese economy are over. Instead, Beijing must content itself with grinding its way through the debt that has accumulated over the past decade.

WANG ZHAO/AFP/Getty Images