- JULY 30, 2009, 3:04 P.M. ET
Companies used to rely on retained earnings. Not anymore.
After second-quarter GDP numbers revealed a rebound in China’s growth rate to near the politically significant 8% level, it is easy to think nothing has changed. When the world grows, China grows, and when the world collapses, China still seems to grow. But don’t be fooled: China’s impressive headline GDP rate masks an important fundamental shift. Its growth is now fuelled by cheap debt rather than corporate profits and retained earnings, and this shift in the medium term threatens to undermine China’s economic decoupling from the global slump.
This logic might seem surprising given the conventional wisdom that China’s growth has always been fueled by cheap credit. Interest rates sometimes have been below inflation, making them negative in real terms, which is a common definition of cheap money. More striking still, the official cost of capital has consistently trailed the return. The implication is that companies can re-invest borrowed money for a higher return than they have to pay back to the banks. In this sense, bank credit is more than free.
If this weren’t enough, overseas money has been piling into China, inflating foreign exchange reserves and domestic liquidity. So perhaps it is not surprising that outstanding bank loans have doubled in the last few years, or that there is much talk of a shadow banking system. Then there is China’s reputation for building overcapacity in its industrial sector, a notoriety it won even before the crash in global demand. This showed a disregard for returns that is always a tell-tale sign of cheap money.
But the reality was more complicated. The government kept interest rates low for the past few years to reduce the attractiveness of the yuan in the eyes of foreign investors, in an attempt to discourage speculative inflows. But the government has used huge financial repression to offset this potential monetary inflation, sterilizing inflows and telling the banks not to lend. The supply of money was thus rationed, logically meaning that the real price of money was higher than the rate officially set by the central bank.
As for China’s loan growth, it was accompanied by equally strong growth in the economy. So China didn’t exhibit the usual surge in the credit-to-GDP ratio that is generally associated with monetary bubbles. As for the shadow banking system, it certainly exists. But the formal banking system was restricted by regulation. Informal lending channels were important but seemed to be used most often for short-term cash needs rather than the financing of long-term fixed investment projects.
The net result was that instead of China having an economy swimming in money, the norm was financial repression that prevented the intermediation of undoubtedly excess liquidity into the domestic economy. What about the perception of overcapacity? This showed up in a mix of two phenomena. First, margins would fall, as companies cut prices to boost sales. Second, asset turnover would deteriorate. Measured as the ratio of revenue over assets, this would show sales volumes weren’t high enough to require using all the productive machines that the company had invested in.
On this basis it was possible to find cases of overcapacity in sectors of the economy in recent years, but not that many. Moreover, the industries that seem to have had too much investment tended to be those dominated by state-owned firms. These companies benefited from the limited supply of loans from government-controlled banks because they were able to offer the collateral that China’s banks demanded—land holdings or a government connection that acted like an implicit guarantee.
China’s private sector, by contrast, was short of collateral and thus starved of cash. This pushed them toward labor-intensive industries that didn’t require as much capital investment, which fortuitously were just the ones that were growing most strongly on the back of overconsumption in the United States. The resulting high top-line revenue growth helped offset weak margins, producing a flow of retained earnings that allowed the private sector to finance itself even without access to bank capital.
But that’s all changing now. The slowdown in U.S. consumption amid a credit crunch has exposed the weaknesses in this export-led financing model. So now China is turning instead to cheap debt for funding, a shift suggested by this year’s 35% or so rise in bank loans.
This change is yielding results, with GDP already jumping back towards the magic 8% level. But this isn’t business as usual. While the previous credit rationing implied higher real interest rates, today’s turbo-charged credit figures show the cost of capital is now very low. The longer this persists, the more likely China in the medium term will face just the overcapacity and bad debt that many observers feared already existed.
Policy makers in Beijing are well aware of these risks, having seen so many credit cycles, both at home and abroad. Indeed, fear of end-game problems when a credit bubble inevitably collapses is exactly what made the government so worried about credit growth and asset prices in recent years. Compounding the problem is the lack of any palatable solutions. Strong global growth between 2003 and 2007 provided a safety net, allowing Beijing to tighten domestic credit without worrying that China’s own growth would collapse. This safety net is gone now.
It’s not impossible for Beijing to take away the punch bowl of credit. There is plenty of room to defy the skeptics and in the next few months and push through structural reforms. For instance, some of the privileges state-owned enterprises continue to enjoy in terms of the ability to provide domestic services like banking and telecoms could be dismantled, allowing the country’s more productive private sector to thrive in local markets rather than just overseas. But without such changes China will be relying on growth financed by cheap domestic debt. This means China will be decoupling itself from the U.S. consumer, but at the cost of a credit bubble.
Mr. Cavey is head of China economics at Macquarie Bank.