China’s economy could be hit by three big problems

By Sourajit Aiyer

This article was originally published by Foreign Policy News USA.

Can the Chinese economic engine really be hit? It is undergoing a transformational change currently, from investment-driven to a consumption-driven one, but that would still enable it to run at a decent speed.

Here are three distinct themes that can severely hit the Chinese engine in the years to come:

OK, so where’s the money?

China has been a bank-run economy, unlike elsewhere in the world where capital markets have become the larger source of funds. The exposure in China is concentrated to three-four large banks, each of which has become so big that it is comparable to the entire banking sector of some nations.

The size of the trust industry and shadow banking are significantly large. Pooling these together, its debt to GDP ratio is estimated to be around 280%, according to a Forbes report. At a GDP of $11 trillion, this means China’s debt is between $28 billion and $30 trillion. That is big! It is about half of the entire world’s debt.

But its economy is growing and its government is trying to reduce lending rates, therefore servicing such huge debt should not be a problem. But the bad news is that China is already burdened by bad-loans, which many believe are much larger than is being let out. Reuters quoted China’s banking regulator as saying that its non-performing loans (NPL) more than doubled in 2015 from 2014, and that the total NPL were around $300 billion.

Overall, NPLs have been increasing for 10 consecutive quarters, and commercial bank NPLs have been increasing for 17 consecutive quarters; $300 billion worth of NPLs means around 3% of its economy. But many in the world believe that this number is under-reported, and that the actual NPL issue may be much larger if Western standards of calculating NPLs are used.

The problem is not whether the banks will fail. They cannot, since most banks are state-owned and most debt is local government debt, hence the government may bear liability. The question is, how will it bear it? Where does it get the money?

High growth rates due to a manufacturing boom helped China accumulate a foreign exchange surplus of $3 trillion. This is an investable surplus, which it is using to flex its geo-political muscle by funding bilateral investment projects in countries across Asia and Africa. If these were used to capitalize the lenders for their NPL problem, it would eat 10% of its reserves.

But this is based on China’s own NPL calculations. If the actual problem is larger or if the coming years accentuate NPLs further, then this would be significantly more than 10%. It would also reduce its investable surplus to fund projects in other countries, forcing those nations look elsewhere.

Given that many of its investment projects abroad combine Chinese funding with contracts for Chinese engineering companies, any reduction in funding would impact business flows for the Chinese firms too.

Its budget is also constrained when it comes to capitalizing the lenders for their NPL problem. Raising money through higher taxes may not be opportune right now, since job creation for the millions of Chinese youth is a key challenge, as seen by the large crowds thronging job-fairs across Chinese cities. Any reduction is budget allocation to other sectors would hit its economy hard, at a time when it is slowing down.

It also cannot fall into a circular chain of debt. Pakistan’s economy highlights the risk of moving into the circular debt conundrum. i.e. raising fresh debt to repay old debt. So China’s banks and lenders will remain under pressure to capitalize themselves against its bad-loan problem, and the question remains: how this money will be raised?

Concrete, concrete everywhere, but not a business to run!

When I was in college, we used to hear a term in the context of China: “economies of scale”. Build a scale so large, that it brings down the average cost of production way below your competitors to enable you add market share. That was an admirable approach, which helped China become the manufacturing capital of the world.

The thing is, they seem to have overdone it. News reports across media show how many factories across the country are facing the heat of low capacity utilization. There is only that much the world can consume, and maybe even less so when the world is reeling under a continued economic slump.

China’s factories are suffering from lower demand, which in turn impacts their ability to pay back the debt they raised from banks and local governments, bringing us back to the earlier challenge. Many factories across the country have shut shop.

Over-capacity also runs into real estate, as there is not enough demand from property buyers for the real estate units. This has led to ghost towns scattered across the country, basically projects where takers are yet to be found.

Not only does over-capacity impact the ability to repay loans, it also impacts new job creation and delay of incomes. Job creation in a country of China’s size is a social challenge, and lack of adequate jobs might only fuel social unrest and dissatisfaction amongst the youth, something its leadership cannot afford right now.

The solution — create more jobs despite businesses in many factories being down. Easier said than done! It might create more jobs in the military, something that goes along its ambitions to extend its military network across various parts of Asia. But that’s still not a commercial employment, i.e. it does not give a boost to business and commerce in the country directly.

The other aspect is that while it is investing to build infrastructure in several countries across Asia through bilateral investment projects, even those countries will emerge as producers of some sort in upcoming years. Otherwise, what will the new infrastructure yield in those countries, and how will they repay any loans they would have taken now for these projects? Even soft-loans have to be repaid.

Their local population will also expect creation of jobs and production activities, and would then become China’s competitors. Intensified competition often means investing in innovation, since the innovative firm is able to garner market share. But China’s current over-capacity might reduce its fiscal muscle to invest adequately in innovation.

The hand that feeds might end up bitten

Remember the stories of Americans allegedly involved with mujahedeen fighters to counter the Soviets in the 1980s, or Pakistan’s ISI allegedly involved with Taliban fighters in Afghanistan in the 1990s? The irony is that these very fighters came back to haunt the US and Pakistan after a few years.

Where this connects with China is if it handles the issue of terrorism selectively. China has significant investment interests in Pakistan. That is good, since an economically strong Pakistan would help its civilian government be more stable. But several terror networks are allegedly based on Pakistani soil.

Its military targets Taliban networks who bomb Pakistan, but not terrorists who bomb India, like Masood Azhar’s Jaish-e-Mohammed, Hafiz Saeed’s Lashkar-e-Taiba, Hizbul Mujahedeen, etc. Countries across the world, and the UN in some cases, have branded them terrorists. But China vetoed an appeal of India against Azhar.

China’s reply – he did not qualify to be considered a terrorist under UN provisions. Ironically, the group headed by Azhar is declared a terrorist group by the US. Earlier, China blocked India’s demand for action against Zaki-ur-Rehman Lakhvi, the accused Lashkar-e-Taiba mastermind of the 2008 terror attacks in Mumbai.

While China may justify its actions saying it is as per guidelines, it must sound ironical that the whole world calls them terrorists, but not China. Either China is wrong, or the world is wrong!

This selective approach to branding terrorists may come back to bite China one day, like it did the US and Pakistan. China is facing a challenge in its restive Muslim-majority Xinjiang region, which borders Pakistan and Muslim Central Asian states.

Its relationship with its neighbours is strong enough to ensure terror networks are not exported into China. But who is to forecast the changes in regional geopolitics in the future? If these terror modules do spread in the next 20 years, China would face internal security challenges. Pakistan’s case shows how internal security challenges severely impede investment flows into the economy.

Could America in the 1980s or Pakistan in the 1990s have thought the same elements would come back to bite them after 20 years?

While China may say its actions with regards to Pakistan-based terror masterminds are as per guidelines, the whole world might say it is because it has billions of dollars of investments in Pakistan. Who is to say these men would not have resorted to bombing Chinese projects in Pakistan, in case China had said otherwise?

It would be a tragedy if this selective approach towards global terrorists comes back some years later to cause severe internal security challenges to China.

This would then impact economic growth by reducing the flow of capital into projects into those very restive areas, which is precisely where China needs to focus more in the coming years for development. Hopefully, such a situation will not occur.

— Sourajit Aiyer works with a leading capital markets company in Mumbai.

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