The Chinese bubble economy: How long will it withstand the pressure?

China's GDP growth slowed down to 7,5% in the second quarter of this year, mostly thanks to faltering exports and retail sales. Albeit, this is still impressive growth, despite the fact that the government will probably miss its annual growth target for this year. There is something to be worried about - it's the way in which China keeps on hitting its growth targets. Here's the WSJ:

"China’s economy is far too dependent on investment–which has in recent years made up around half of all growth. Household consumption, meanwhile, was just 38% of GDP in 2011–some 20 to 25 percentage points below the consumption rates among China’s neighbors ...  

China’s massive investment rate all but guarantees vast amounts of malinvestment. In other words, plenty of these resources haven’t really been invested but rather have been consumed in altogether unsatisfying ways that have made people marginally better off in the near term (keeping people in work and oligarchs rich) while doing nothing to expand the economy’s productive potential and thus nothing to boost standards of living long term. Whole new cities are likely to rot away, abandoned and useless like stranded Mary Celestes. 

Worse still, it takes ever larger infusions of money and credit to keep up the pace of growth."

And this brings us to the current state of the Chinese bubble economy and it's recent bank bailout. With so much credit being pushed into the system to sustain the government growth targets, it's only a matter of time before the whole thing bursts. And as China sneezes...

Source: WSJ. Click to enlarge.

...the rest of Asia (and the world economy) shivers.

To remove this dependency of the Chinese growth model on (mal)investments and switch it to consumption requires a real restructuring of the Chinese economy. Something which its leaders have pledged to do, announcing liberalization of product markets, helping private entrepreneurs to compete with state-owned ones (causing a fair share of resistance form state owned CEOs and ideological party members), and even delivering statements like the one from Prime Minister Li Keqiang saying that "the state should remove its hands from many parts of the economy, even if doing so felt like cutting its own wrists." However, it doesn't seem the situation has reached a boiling point quite yet. Not even after the "hiccup" of the Chinese banking system last month.

When the money stops pouring

Last month's panic started on the Chinese interbank lending market (where banks borrow from each other to gain temporary liquidity) when the People's Bank of China (the central bank) refused to inject liquidity into the market when things got too tight. Usually it always does so in order to sustain the boom it has created (i.e. meet its credit targets, which the Bank finds more important than financial stability). The reason for no reaction this time was to show clear commitment that it aims to tighten its policy on credit growth, and curb the shadow banking system. As a result interest rates hiked (see graph below), the stock market went down, and some banks found themselves in serious trouble.

However, all of this was an inevitable consequence of the Chinese artificially overheated growth model. Here's from the FT: 

"China powered through the global financial crisis in large part thanks to an explosion of credit, first through the formal banking system and then through a series of “shadow banks” and off-balance-sheet vehicles. The result has been a remarkable increase of leverage in China. The overall credit to gross domestic product ratio has shot up from about 120 per cent to nearly 200 per cent over the past five years."

This is what its CB is trying to fix; the oversized shadow banking system. The very same one they helped create and fueled over the past decade. Many lenders seized the opportunity to borrow at low rates on the central bank-controlled interbank market, so that they could use this money to make risky, high-return investments. Many small banks also took the risk of borrowing short and lending long, which is ok if they can roll over their borrowing on the stable interbank market. Hence the panic when the CB pulled out. Yet another example is balance-sheet mischief. The Economist reported that "Many banks sell wealth-management products (WMPs) to investors that mature just before the end of the quarter. The repayments are paid into the bank’s deposits in time for regulatory inspections, only to disappear into a new product immediately afterwards. Meanwhile, the bank needs to borrow the funds it repays to the products’ buyers." Greed for profit? Absolutely. In China? How can this be? 

Source: Financial Times. Click to enlarge.

It's all about incentives. Party leadership and the CB have given clear signals to the market to act risky and pile up leverage in order to sustain the enormous credit boom necessary to fuel the economy. This is important in order to keep hitting government-set growth targets, which are a pure political factor chosen by party leadership to show the West that having high rates of growth for so long is possible and, more importantly, that it is sustainable. In order words to show the West that state capitalism is the way to go. Unfortunately, this fairy tale will soon be over. Even if we accept the premise that the banking system is robust to failure due to its closed nature and unlimited protection from the government, the unprecedented credit boom and shadow banking system growth cannot last forever. This has been proven time and time again. 

The new party leadership has certainly realized this and are striving for restructuring and reform. Progress so far has been slow. This is somewhat understandable since party leadership cannot jeopardize its long term political goals, nor can it allow for the economy to go down too fast and risk a recession on their hands. I'm sure that in terms of confidence loss China wouldn't be hit as hard as the US or Europe (party propaganda can do wonders), but it terms of a systemic failure it could get even worse. Something like Japan in the 90-ies after it reached the end of its rapid boom. After the crisis, China will most likely apply similar policies Japan did to offset it (I covered some of them here), meaning that China too is facing several decades of stagnation. Unfortunately, for China this will all happen too soon; i.e. before it's people started experiencing true consumerism and higher living standards. 

Finally, after all of this, who can honestly say China isn't capitalist? The fact that it has a capitalist system run by central-planning, short-term target-oriented socialists, only makes it more fragile and extremely dangerous in terms of potential consequences. Consequences that will, because of China's size, affect the global economy. Let's just hope this all happens when the West comes out of its recession. Time is running out.