For the past two decades China’s turbocharged growth has been the envy of the rich world as well as an aspiration for other emerging markets. Surging exports and intensive state-driven investment have lifted millions out of poverty and propelled Beijing into the exclusive club of global economic superpowers.
More recently, however, doubts have emerged over the sustainability of this development model. In particular, critics point to China’s increasing addiction to cheap credit, which began when Beijing unleashed its large-scale monetary stimulus at the height of the financial crisis. Between 2008 and 2012, China’s total debt as a proportion of gross domestic product nearly doubled, jumping from 125 per cent to 215 per cent.
This rise would not have been so problematic if the cash had been used to fund profitable investment. However, the opposite is often true. The more vibrant segments of the private sector, including many small and medium-sized enterprises, are typically starved of cash. Meanwhile, the larger state-owned enterprises, as well as local governments, enjoy easy access to loans, which they then squander in redundant projects offering low rates of return.
At the third plenum of the Chinese Communist party’s 18th Central Committee last November, the leadership in Beijing vowed to let market forces play a bigger role in the economy, including in the way loans are allocated. Yet any reform is likely to be incremental. For this reason it is essential that the authorities keep a lid on the overall growth of credit. Were lending to spin completely out of control, Beijing could face a wave of defaults that would undermine financial stability.
Encouragingly, the Chinese government has taken several steps to shore up the system. Last summer Beijing launched an audit of China’s local authorities. The results, which were published in December, showed that the liabilities of China’s municipalities have risen by nearly 70 per cent in three years, reaching Rmb17.9tn ($2.95tn). Since no independent assessor was involved in the process, there is a risk that its results were politically massaged. Still, the exercise sends a powerful signal to local governments that the old borrowing ways are no longer acceptable.
Meanwhile, the People’s Bank of China is also striving to squeeze liquidity out of the banking system, allowing money rates to rise. So far its results have been mixed. True, rates are significantly higher today than they were in the first half of 2013. But the central bank is discovering just how difficult it is to tighten monetary policy without creating a market panic. Last year, on two separate occasions – one in June, the other in December – a spike in the interbank lending market forced the monetary authorities to inject liquidity in order to ease the crunch.
Beijing faces a difficult conundrum: it will be hard to reconcile the desire to rein in credit with the aspiration to meet ambitious growth targets. The leadership wants the economy to expand by 7.5 per cent in 2014, which is roughly in line with the performance of 2013. And while local politicians have been told that they will be assessed against a wider set of indicators than purely growth, the precise ranking of objectives remains unclear.
Of course, Beijing cannot let its economy slow down too suddenly. This would trigger the very wave of defaults it is trying to avoid. But rather than fixating on a single figure as it has done so far, the government should put greater emphasis on the composition of growth. Since the third plenum, the leadership has raised expectations that it is serious about ending the country’s dependence on debt. Its credibility – and the future prosperity of China – hinges on actually meeting this goal.