China vs. Japan Debt Capacity; Impact of Debt on Chinese Growth; Chinese Recovery On Paper

Courtesy of Mish.

Chinese Recovery On Paper

Is China really growing at the reported 7.5% rate? I have frequently stated "no chance". Malinvestments in housing, vacant cities, vacant malls, and roads with no traffic prove the point. Michael Pettis at China Financial Markets reiterates that view in regards to credit expansion and GDP growth.

First, please consider the New York Times article Chinese Recovery On Paper.

The National Bureau of Statistics in Beijing announced on Wednesday that economic growth climbed 7.5 percent in the second quarter, compared with a year earlier. But independent surveys of businesses across China show that in sector after sector, sales and confidence are still deteriorating.

“All of them are pointing in the opposite direction from this supposed G.D.P. number,” said Leland Miller, the president of China Beige Book International, a New York data service that surveys 2,200 private businesses across China each quarter to gauge economic activity.

One of the biggest engines of Chinese economic growth in recent years — construction and other investment in the private sector — is sputtering, while exports have only begun to recover from a weak winter and retail sales growth is leveling off. That leaves government investment and spending, which are running strong, propelled by redoubled lending this spring by the state-controlled banking system to the national railroad system, local governments and state-owned enterprises.

The result has been frenzied spending on the construction of railroad lines — up 32.1 percent in June from a year earlier — and subsidized housing. Steel output in China is setting records by tonnage as a result, even as the number of housing starts in the private sector is falling steeply.

Total lending has now risen faster than economic output, even before adjusting for inflation, in every quarter since late 2011. Lending accelerated further in June, according to figures released on Tuesday by the central bank, the People’s Bank of China. Yet Mr. Miller’s survey and others show that private businesses are becoming less and less interested in borrowing money because they see few opportunities to invest it profitably.

“Although there is no way to predict with accuracy and certainty the point at which China will reach the limits of its debt capacity, I believe that current rates of credit expansion can continue at most for another 3-4 years,” Michael Pettis, a finance professor at Peking University’s Guanghua School of Management, wrote in his newsletter after the release of the data.

From Pettis via Email

Impact of Debt on Chinese Growth
 

• Over the short term Beijing can successfully target nearly any GDP growth rate it chooses as long as two conditions are fulfilled. First, it must be willing to allow credit to expand as rapidly as required to achieve the GDP growth target. Second, it must have enough debt capacity for credit to expand at the required rate.
• Although there is no way to predict with accuracy and certainty the point at which China will reach the limits of its debt capacity, I believe that current rates of credit expansion can continue at most for another 3-4 years.
• Growth in credit can be subject to “sudden stops”, especially when external financed, but even in systems in which sudden stops can be controlled, like that of China, debt capacity is nonetheless limited.
• In the case where a significant amount of new debt is used to fund projects whose economic value is less than the value of the debt, and in which the gap between the two is not recognized and written down, the debt capacity limit is reached when credit growth is not enough to exceed the acceleration in the rolling over of unrecognized bad debt.
• Maximum debt thresholds in rich, developed countries are much higher than they are in poor, developing countries. Even though analysts often do this, comparing China’s debt ratio with that of a developed country like, for example, Japan, tells us nothing about China’s relative ability to manage its debt burden.
• Failure to recognize bad debt overstates reported GDP growth. Once a country stops accumulating bad debt, however, its reported GDP growth will be understated by the same amount by which it had previously been overstated.
• Debt is not neutral to economic growth. When a country has “too much” debt, market perceptions of its deteriorating creditworthiness cause agents to change their behavior in ways that reduce growth to less than what it would have been without the debt. This process can be intensely self-reinforcing.

In my many meetings with investors around the world, some of the most urgent questions I get about China’s future growth prospects have to do with attempts to understand the very different kinds of debt constraints that China faces from those faced by the US, Europe and Japan.

I will argue that, like for any country, there are two important consequences of China’s current debt burden that will affect China’s future GDP growth….