While all eyes are still on Turkey, another emerging market is about to show the ugly side of quantitative tightening, and this time things could get really serious.
The world’s second largest economy has been a “success story” for so long that people have forgotten about China’s many vulnerabilities. Or rather, the Chinese communist party has been so good at keeping things under wraps, that few of the country’s weaknesses are known to the outside world.
But now, the US Fed and China are in a monetary policy staring contest, and China will probably blink first. However, when it does, this will have serious negative consequences on the rest of the world, including the US.
China looks good if you consider the main indicators. The economy is growing at more than 6% (although some analysts dispute that figure), while consumer price inflation is still low at 2.1% (the latest available data, for July).
But its fantastic economic growth has been built on a mountain of debt. China’s total debt is approaching 300% of gross domestic product, on a par with that of much wealthier countries. With the Fed raising rates and the European Central Bank planning to stop asset purchases soon, that debt will not be so easy to service.
A warning of how serious this is can be read in a working paper published by the IMF in January this year, authored by Sally Chen and Joong Shik Kang: “In addition to the large stock of existing debt, the length of China’s current credit boom is the longest in our observation and ongoing. A disorderly correction from such an expansion could have far-reaching implications on financial stability and growth.”
The IMF’s Article IV consultation staff report published in June this year noted that “while credit growth has slowed, it remains excessive”. Its projections show the debt as a percentage of GDP continuing to climb.
In the meanwhile, China’s current account surplus, which was considered by some to be a cushion for the country in case of financial crisis, is set to keep shrinking as the economy is set to feed more on domestic consumption rather than exports.
Signs of strain on the debt front are already appearing. Peer-to-peer (P2P) lending, which was first introduced in China in 2007, had been growing strongly until not long ago. In the five years to 2017, the peer-to-peer lending industry had enjoyed annual growth rates of around 60%, according to a research paper authored by Jinglin Jiang, Li Liao, Zhengwei Wang and Xiaoyan Zhang.
But last week, the Chinese financial markets regulator enlisted the help of the four bad debt companies the government created more than 10 years ago to deal with the bad loans during the financial crisis, to help clear the crisis in the peer-to-peer lending sector, according to a report by Reuters.
Since June, more than 240 online Chinese peer-to-peer lending companies went bankrupt, triggering protests by P2P investors who have lost their life savings. If there is one thing the Chinese government does not want, it is protests; so avoiding a debt implosion that would cause problems to savers is high on its agenda.
The Chinese government faces a big unknown in the form of Fed policy. Unlike his predecessors Ben Bernanke and Janet Yellen, Fed Chair Jerome Powell doesn’t seem to be too concerned about emerging markets when calibrating monetary policy. The world’s first and second economies are now in a monetary policy staring contest. China will probably blink first.