Widespread corruption at the local government level remains a threat to China’s economic development. If stories are to be believed, Chongqing’s disgraced party boss Bo Xilai even used an anti-corruption drive to put the squeeze on local business people. Beijing faces more immediate problems, however. Recent policies have pushed the country’s well-known macroeconomic imbalances to extreme levels, its real estate market is glutted and its credit system appears increasingly vulnerable.
Premier Wen Jiabao has talked repeatedly of the need to address China’s “imbalanced, uncoordinated, and unsustainable development”. Yet its growth continues to depend on increasing amounts of investment. Last year fixed-asset investment accounted for 90 per cent of economic growth. The trouble is that much of the money has been frittered away on trophy infrastructure projects, such as the country’s expensive high-speed rail network, with low prospective returns. Mr Wen may fret but if investment were to stop expanding, China’s growth rate would slow dramatically. Beijing is holding a tiger by the tail and doesn’t dare let go.
One area of particular concern is the residential real-estate market. After years of overbuilding, tens of millions of apartments sit empty. In 2011 housing supply exceeded demand by about 50 per cent, according to UBS. For two years, Beijing has acted to damp speculation in the housing market. In January home prices fell in the majority of the 70 mainland cities surveyed by the National Bureau of Statistics. Most people believe that real estate will rebound as soon as policy is loosened, but recent experience from the US, Spain and Ireland suggests that overbuilt housing markets take years to correct. This could spell bad news for China, where residential construction accounts for about 13 per cent of gross domestic product.
China’s state-controlled banking system is also running into trouble. In 2009 banks were ordered to make massive loans to local government infrastructure projects in order to stave off a recession. Much of this money has been wasted and the banks are now required to roll over potential non-performing loans. Local governments can’t afford to bail them out because their main source of revenue, land sales, has dried up. In the past, the banks got away with weak lending practices because they earned fat profit margins on deposits. The rapid expansion of deposits has allowed China’s banks to outgrow bad debt problems. Savers, who received negative real interest rates on their deposits, have subsidised the banks. They had little choice because capital controls prevented them from taking money offshore and had nowhere else to put their money.
The state’s ability to control savings is weakening, however. As China’s connections with the outside world have deepened, capital controls are less effective. Rich Chinese, who own the lion’s share of deposits, have been moving capital abroad. Recent declines in the country’s foreign exchange reserves and renminbi deposits in Hong Kong suggest capital outflows are rising. Most of the credit growth in recent years has appeared in China’s “shadow” banking system. The rapid expansion of non-bank credit is a “de facto deposit rate liberalisation”, according to Charlene Chu of Fitch.
New credit instruments have enabled debt levels to balloon despite restrictions on bank loan growth. Trust loans have financed cash-strapped developers. Loans in the shadow banking system tend to have short maturities. Over the past year, the banks have suffered periods of declining deposits. The interbank loan market has also been stressed. All of the evidence points to rising financial fragility at a time of acute weakness in the real-estate market.
This fragility was dramatically exposed last September when a credit crunch in the shadow banking system produced a wave of failures in the southern coastal city of Wenzhou. Several months on, this event is almost forgotten. Yet much of the recent data – whether on housing starts, power generation, steel and cement production, auto sales, capital goods imports or air freight – suggest broad economic weakness.
The Chongqing saga reminds us that public corruption is never far from the surface in China. This problem could be sidelined if the economy was to keep growing rapidly. But policies that have delivered in the past are losing their efficacy. Ever greater amounts of credit and investment are needed to help maintain the same level of GDP growth. The banks can no longer direct cheap capital into wasteful investment projects without encountering resistance from depositors. China’s main export markets are weak and its current account surplus is vanishing. As China’s vast pot of surplus savings diminishes, Beijing’s vaunted policy makers may find that they have run out of options.
The writer is a member of GMO’s asset allocation team and author of ‘Devil Take the Hindmost: A History of Financial Speculation’