Will China's financial sector go boom? What about China's government?

An out-of-control shadow banking system that's been barely reformed. A housing sector that's been booming but seems primed for a bust. And despite a recent election that seemed to make it clear who was in charge, gridlock and short-term thinking appear to be hobbling the country's political elite. 

I'm talking, of course, about ... China. Well, not me so much as Fitch Ratings, which has turned just a bit bearish on Chinese debt. Why did Fitch downgrade their debt?  

China's growth since the re-launch of market-based economic reform in 1992 has been globally as well as domestically transformative. However, the investment-led growth model faces tightening constraints as the share of investment in GDP approaches the level of domestic savings. The process of rebalancing the economy towards consumption could lead to the economy's performance becoming more volatile.

Some underlying structural weaknesses weigh on China's ratings. Average income at USD 5,988 in 2012 and the overall level of development remain well below 'A' medians despite China's phenomenal growth. Standards of governance lag 'A' range norms according to the World Bank's assessment framework....

Risks over China's financial stability have grown. Credit has grown significantly faster than GDP since 2009. China experienced the second-fastest expansion of credit in real terms, behind only Qatar, between end-2009 and end-June 2012. The stock of bank credit to the private sector was worth 135.7% of GDP at end-2012, the third-highest of any Fitch-rated emerging market.

Fitch believes total credit in the economy including various forms of "shadow banking" activity may have reached 198% of GDP at end-2012, up from 125% at end-2008. Only 55% of new social financing took the form of bank lending in the 12 months to February 2013, down from 76% in 2009. The proliferation of other forms of credit beyond bank lending is a source of growing risk from a financial stability perspective....

The ratings assume there is no significant deterioration of geopolitical risk, for example a conflict between China and Japan or an outbreak of war on the Korean peninsula.

Well, to be fair, despite daily headlines to the contrary, the chance of war breaking out on the Korean peninsula still seems pretty remote. Still, the Financial Times puts this downgrade in context

China has faced concerns over debt levels since 2009 when state-owned banks unleashed a surge of loans to power the economy through the global financial crisis. The credit wave succeeded in keeping Chinese growth on track, but it led to bubbly housing prices and also saddled local governments with mountains of loans that they are still struggling to repay.

Beijing has spent the past three years trying to manage these problems. It has waged a long campaign to rein in the real estate sector, raising mortgage downpayments and barring people from buying second homes in the hottest markets. Partly as a result, China recorded its lowest annual growth rate for a decade last year.

Reuters tells a similar tale on China's shadow banking system.   

China's banks are feeding unwanted assets into the country's "shadow banking system" on an unprecedented scale, reinforcing suspicions that bank balance sheets reflect only a fraction of the actual credit risk lurking in the financial system....

But the key question is no longer how much risk banks are carrying. Rather, it's how many risky loans have been shifted to the lightly regulated shadow banking institutions - mainly trust companies, brokerages and insurance companies.

The risk to the overall financial system is not clear, because of insufficient data about the quality of credit in the shadow banking sector.

To be fair to Chinese authorities, they're quite aware of what they're going through. Indeed, the entire China 2030 exercise, as well as last month's China Development Forum, is predicated on the notion that China's growth model needs to change. But as Martin Wolf notes in his column, as China enters "middle income trap" territory, there are significant problems with such reforms: 

First, if expected growth falls from over 10 to, say, 6 per cent, the needed rate of investment in productive capital will collapse: under a constant incremental capital output ratio the fall would be from 50 per cent to, say, 30 per cent of GDP. If swift, such a decline would cause a depression, all on its own.

Second, a big jump in credit has gone together with reliance on real estate and other investments with falling marginal returns. Partly for this reason, the decline in growth is likely to mean a rise in bad debts, not least on the investments made on the assumption that past growth would continue. The fragility of the financial system could increase very sharply, not least in the rapidly expanding “shadow banking” sector.

Third, since there is little reason to expect a decline in the household savings rate, sustaining the envisaged rise in consumption, relative to investment, demands a matching shift in incomes towards households and away from corporations, including state enterprises. This can happen: the growing labour shortage and a move towards higher interest rates might deliver it smoothly. But, even so, there is also a clear risk that the resulting decline in profits would accelerate a collapse in investment.

I'd add only two things at this point. First, as far as I'm concerned, one of the great mysteries in comparative political economy is why it's so bloody difficult for countries like Germany, Japan, and China to change their growth models. High-saving export-oriented economies don't change their ways all that much. To be fair, neither do low-saving, high import countries like the United States. This could be a "varieties of capitalism" story, but that seems ... inadequate as an explanation. 

Second, it's worth remembering that the conventional wisdom about China's government was that annual growth below eight percent a year would spell trouble for the government. The implicit contract over the past three decades was that the Chinese Communist Party would supply the growth in return for political quiescence. The end of high growth would imply that this social contract is in trouble.

Except that China's growth has been below that rate for the last two years and running. During that time, Beijing has weathered one major political scandal, a raft of minor political scandals, and a leadership transition without a hint of regime collapse. So while China's economy does seem to merit greater attention, I'm not sure that China's political economy will trigger the kinds of instability that have been predicted for so long. 

What do you think? 

Daniel W. Drezner

How Margaret Thatcher affected international relations theory

Margaret Thatcher has passed away. I could try to talk about Thatcher's place as a world historical figure, but let's face it, there's going to be an orgy of columns on that very point over the next week or so -- anything I write on the topic would be second rate at best. I could write about my own memories of living in London during the late Thatcher era, but to be honest, that's not terribly interesting -- it's a tale of fading political popularity and really strident left-wing art. 

So, instead, consider the following two ways in which Thatcher has left a legacy in international relations theory:  

1) Diversionary war. There's a large literature in international relations on the notion of using war against a foreign adversary as a way to distract domestic opposition and/or bolster domestic support for a leader (see Chiozza and Goemans for the latest iteration of this literature). It's a little-known fact, but International Studies Association rules prohibit any paper on this topic from being published without a Thatcher reference.  

I kid, but only barely. The Falklands War represents the paradigmatic case of diversionary war theory for two reasons. First, almost every analysis of the conflicts attributes the Argentine junta's growing domestic unpopularity as a key cause of their decision to launch the conflict (though, of course, it's a bit more complicated than that). Second and more importantly, absent the Falklands War, Margaret Thatcher would be remembered as a failed one-term prime minister. Victory over the Argentines in the South Atlantic enabled Thatcher to win re-election.  

In truth, it's far from clear that diversionary war is all that common a practice (if it was, we'd be drowning in conflicts since 2008). The Falklands War, however, does provide the paradigmatic case.

2) The spread of ideas. It's fitting that the New York Times ran a story over the weekend about the boomlet in history about studying the growth of capitalism. Thatcher's role in advancing the spread of free-market ideas to other policymakers was crucial. To explain why free-market capitalism became the pre-eminent idea in economic policymaking over the past few decades, you have to look at Thatcher. She preceded Reagan, becoming the first leader in the developed world to try to change her country's variety of capitalism. Even after Reagan came to power, one could persuasively argue that Thatcher mattered more. As some international political economy scholars have noted, ideas and policies spread much faster when "supporter states" embrace them vigorously rather than reluctantly. Thatcher embraced capitalism with a near-religious fervor, acting as a vanguard for the rest of Europe on this front. For more on the role that Thatcher and her advisors played, see Yergin and Stanislaw's The Commanding Heights, or Jeffry Frieden's Global Capitalism

OK, readers, in what other areas of international relations and comparative politics did Margaret Thatcher leave her mark?