China: A Crisis in the Shaping?

Data Sourced from The World Bank

China needs structural reform; something that can overhaul its economy and at the same time, maintain its growth trend.

Efforts to secure a viable future, by financing struggling firms and engaging employment may be one of its many efforts towards sustained economic growth.  An increased month-on-month money supply (M2) in June, and policy controls on shadow banking are some initiatives being taken by the central bank, in order to balance growth and credit risk. However, such efforts have come with the added cost of credit expansion. At 250 percent of GDP, China’s total debt to GDP ratio stands at one of the highest globally. Infact, consumption has decreased substantially, especially since the year 2000 (see graph), indicating liquidity crunch across the economy, and a probable impending slowdown (further).

Credit expansion, when traced in the European economies, has been both a cause and effect of economic issues faced before, during and after the financial crisis of 2007-08. Gradual increase in aggregate demand and mainly, development of the housing market in the pre-crisis period (2004), and improvement of banking services, helped the initiation of a more fluid market for investors as well as savers. Moreover, since a section of consumers was liquidity-strapped, some liquidity constraints were removed. In 2004-05 alone, household credit increased to 38 percent of total bank loans from just 23 percent in 2000.

An inevitable, if not impossible consequence of credit expansion is an asset price bubble. China reported increases in house prices in 65 of its 70 major cities, this year. So much so, that acquisition of land has become expensive. Every transaction, right from acquisition of land, to construction, to buying the property (by the ultimate buyer), has been through loans, owing to rising prices in the chain.  Its mounting bad loans had China resort to some good strategies like packaging debt as securities to attract investors. However, illiquidity and complexity of these securities discouraged many investors. A government bailout may seem the only solution at this juncture.

Past crises indicate that the distinct reasons for such situations are lack of market discipline and risk sharing. Lack of market discipline is accompanied by incongruous risk valuations by investors and/or financial participants. This may lead to asset price increases, and then decreases in these prices, if valuations do not match expectations. Such volatility leads to over-lending and indebtedness. On the one hand, rapid credit expansion would lead to greater aggregate demand than supply, and put excessive pressure on firms. A potential current account deficit with larger imports than usual, may be the consequence. On the other hand, such credit expansion may lead to large-scale financial instability. Infact, credit booms, banking crisis and currency crisis are all correlated, and are some significant causes of macroeconomic instability.

In case of China, underlying risk is correctly illustrated by the ‘catching up’ hypothesis.  Risk assessment and taxation of credit seem two popular methods of managing such rapid credit expansion. Another method that could be opted for is the use of credit to offset past credit, especially in case of smaller private sector loans. A more detailed review of customer profiles, loan purposes, past credit history, market conditions, and such may help banks disburse credit more wisely.

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