Beware of Overtightening Credit in China

There is concern over the Chinese authorities' credit tightening plans for 2008, writes Qing Wang in his China Economics review for the latest Morgan Stanley Global Economic Forum. This concern focuses on the possibility of a credit overtightening:

If the credit tightening, together with other macro-control measures (e.g., tighter scrutiny over approval of investment projects), is consistently implemented, it will likely result in a significant slowdown in real activity...

Distinguishing between the two types of overtightening is important for understanding the broad market implications. Overtightening due to policy mistakes would likely result in a hard landing of the economy, and its negative market impact would be serious and broad-based. On the other hand, overtightening due to policy constraint would have a disproportionately large negative impact on domestic demand-oriented sectors, while export-oriented sectors would be less affected...

[We] found that sectors with higher debt-asset ratios tend to experience larger declines in fixed-asset investment growth after credit tightening is imposed. We looked at the most recent debt-asset ratios for 42 industries. Several sectors including the coal mining and other mining, construction, retail and wholesales and real estate have high debt-asset ratios. Among the manufacturing sectors, heavy industries (e.g., machinery & equipment, metals) tend to have higher debt-asset ratios than light industries (e.g., textile, food). These sectors of high debt-asset ratios would likely be – other things being equal – vulnerable to credit tightening.

Second, small- and medium-sized enterprises are generally at a disadvantage relative to large ones in the event of credit tightening. This is mainly because administrative tightening inevitably involves some degree of credit rationing. Large enterprises tend to have close and long-standing ties to banks and greater lobbying power with policy makers, thus providing easier access to bank credit and policy makers’ approval of investment projects. In this context, macro tightening tends to lead to industrial consolidation, with large enterprises taking over small ones or the latter simply exiting the market.