The news during the Chinese Communist Party Congress was supposed to be uniformly positive. But the Oct. 19 press conference of Zhou Xiaochuan, the governor of China’s central bank, was not. After admitting that the country’s high debt was high, he surprised everybody by adding that it was not so high as to cause a “Minsky Moment,” a sudden meltdown of asset prices. It was a fascinating insight into what worries China’s economic leaders and the tough choices they face.
Hyman Minsky, an American economist who died in 1996, studied financial crises. He became famous posthumously when experts turned to his writings to explain the 2007 meltdown of the subprime mortgage market. Minsky argued that investments that generate sufficient cash flow to repay their debt are safe while those that must be sold for a higher price are risky. He called the latter Ponzi schemes and noted that they result from excessive borrowing and overconfidence after periods of uninterrupted growth. Ponzi schemes end abruptly when overleveraged investors find no new buyers for their overpriced assets. With panicked investors trying to all sell at the same time, assets prices fall very fast, very far, and stay low for a while.
China’s debt level is worrisome. In an August 2017 report, the International Monetary Fund (IMF) predicted that China’s total non-financial sector debt will rise to almost 300 percent of its GDP by 2022, up from 242 percent last year. The IMF warned that China’s credit growth was on a “dangerous trajectory.” The Bank for International Settlements, a Switzerland-based bank for central banks, wrote in late 2016 that China’s excessive debt growth was signaling a banking crisis in the next three years. And the world’s top rating agencies, Standard & Poor’s and Moody’s, downgraded its sovereign rating in 2017. China’s debt level is comparable to that of the United States but much higher than for any developing country.
Much of this debt was incurred during the Great Recession of 2007-09 when China wanted to avoid the severe economic contraction affecting the rest of the world. It enacted an unprecedented $586 billion stimulus package and financed it through easy credit. Perhaps it was the right decision at the time, but the credit spigot was not turned off when the economic emergency ended, and China’s debt kept growing. Most of the debt has been incurred by commercial borrowers, especially state-owned enterprises. But even Chinese households, traditionally net savers, started borrowing, usually to speculate on real estate.
Statistics on loan defaults are unreliable. Official reports put bad debt at just under 2 percent, but many independent analysts think it is actually between 15 percent and 30 percent. There are two useful precedents for China when it starts dealing with bad debt. During the Great Recession of 2007 to 2009, the U.S. rescued some firms but allowed others to go bankrupt, including prominent ones like Lehman Brothers. The result was a deep but relatively short recession followed by a healthy recovery. Japan chose differently. Its impressive GDP growth in the 1970s and 1980s resulted in overconfidence, easy credit and a huge real estate asset bubble that burst in 1991. Japan rejected the bitter medicine of widespread bankruptcy, propped up both lenders and borrowers, and ended up with zombie enterprises that have been slowing down the entire economy. As a result, Japan has had almost no growth since the 1990s.
Gov. Xiaochuan is probably right that China will avoid a Minsky Moment. A lot of China’s bad loans were made by state-owned lenders to state-owned enterprises. So they will extend and pretend: extend the maturity and pretend the debt is good. If cash needs are pressing, the Chinese government can advance emergency funds. Its foreign currency reserves are vast and with sovereign debt at just 40 percent of GDP, it can borrow in the international markets.
But growth will suffer. China announced at its Congress that overall indebtedness must come down and the era of easy money is over. With no new funds, overextended lenders working out bad debt will lend less than before, even to healthy companies. And borrowers who financed their growth with debt will spend their profits to repay debt instead of investing for growth.
Slow growth has been a deep concern of the Chinese Communist Party ever since the quick and undignified end of the Communist Soviet Union. The unspoken social contract in China is that the people will not ask for freedom if the Communist dictators deliver economic growth and an improving standard of living. But with slow growth in China, still a developing country, social unrest becomes quite likely.
China’s economic progress has been the marvel of the world for decades. Going forward, though, two of its main growth engines will no longer push forward, but will go in reverse. China’s working-age population stopped growing in 2015 and is now shrinking. And new debt will no longer fuel growth. On the contrary, borrowers will start repaying loans. China has many challenges ahead.
• J. William Middendorf II is chairman of the Committee for Monetary Research and Education. Dan Negrea is a New York private equity investor.
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