China update

China's alarming obsession with debt is arguably the biggest concern regarding the country's economic growth prospects. Morgan Stanley's Chetan Ahya puts the scale of the problem in perspective,

China’s debt has risen from 147 per cent of GDP in 2007 to 279 per cent of GDP in 2016. Last year, China added 21 percentage points to its debt-to-GDP ratio, or the equivalent of $4.5tn. In effect, China needed almost six renminbi of new debt to grow its nominal GDP by one renminbi... only two economies which have a population of above 20m have been able to escape the middle income trap, in which rapidly growing economies stagnate at middle-income levels, over the past 30 years. Those were South Korea and Poland.

But, despite this, there is a rising tide of opinion that China may have done enough to overcome the worst fears. A recent Morgan Stanley China report clearly came out bullish on China. Its arguments for macroeconomic stability focus on Chinese debt being funded domestically, its very big external balance sheet with net international investment position of 16% of GDP, low inflation effect due to credit allocation being used to fund investment, political acceptance of lower growth going forward, potential for rebalancing towards consumption, reforms to transition away from low value manufacturing, and the sure signs of moving towards high value added manufacturing. 

This blog has been inclined to the view that China's growth momentum was built on strong enough foundations and, coupled with its unique size and fairly enlightened government unencumbered by the troubles of democratic politics, meant that the country could potentially tide over these problems without a hard landing. It has built everything that India does not have - human, physical, financial, and institutional capital - to sustain a high (relative to its income levels) growth trajectory. 

However, there are two concerns. The size of debt is massive and these numbers do not accurately reflect the non-bank sector debts. For corporates and local government entities, an orderly deleveraging cannot be taken for granted. Apart from the economic contagion from lurking potential too-big-to-fail dangers, there is also the likelihood of social disruptions from job losses and so on.  

Further, despite its net positive external investment position and foreign exchange surpluses, that channel may not be as secure as we believe. In a couple of years, a trillion has been wiped off from the reserves, and a significant proportion is not liquid enough to be drawn for use. In case of external and, more critically, internal events, if the renminbi becomes a one-way downward bet, then the flight of domestic savings capital from China itself and efforts to prop up the currency could end up rapidly eating up the reserves buffer. And then we could have a different scenario.

I am therefore not surprised that Michael Pettis holds the view of a "gradual decline in GDP growth to below 3 percent by the end of this decade, or shortly thereafter".