Thursday, November 20, 2014

The Politics of a Slowing China

SINGAPORE – The recent financial turmoil in China, with interbank loan rates spiking to double digits within days, provides further confirmation that the world’s second-largest economy is headed for a hard landing. Fueled by massive credit growth (equivalent to 30% of GDP from 2008 to 2012), the Chinese economy has taken on a level of financial leverage that is the highest among emerging markets. This will not end well.

Indeed, a recent study by Nomura Securities finds that China’s financial-risk profile today uncannily resembles those of Thailand, Japan, Spain, and the United States on the eve of their financial crises. Each crisis-hit economy had increased its financial leverage – the ratio of domestic credit to GDP – by 30 percentage points over five years shortly before their credit bubbles popped.

Economists who insist that China’s financial leverage is not too high are a dwindling minority. Certainly the People’s Bank of China, which engineered a credit squeeze in June in an attempt to discourage loan growth, seems to believe that financial leverage has risen to dangerous levels. The only questions to be answered now concern when and how deleveraging will occur.

At the moment, China watchers are focusing on two scenarios. Under the first, a soft economic landing occurs after China’s new leadership adopts ingenious policies to curb credit growth (especially through the shadow banking system), forces over-leveraged borrowers into bankruptcy, and injects fiscal resources into the banking system to shore up its capital base. China’s GDP growth, which relies heavily on credit, will take a hit. But the deleveraging process will be gradual and orderly.

Under the second scenario, China’s leaders fail to rein in credit growth, mainly because highly leveraged local governments, well-connected real-estate developers, and state-owned enterprises (SOEs) successfully resist policies that would cut off their access to financing and force them into insolvency. Consequently, credit growth remains unchecked until an unforeseen event triggers China’s “Lehman” moment. Should this happen, growth will collapse, many borrowers will default, and financial chaos could ensue.

Two intriguing observations emerge from these two scenarios. First, drastic financial deleveraging is unavoidable. Second, Chinese growth will fall under either scenario.

So, what impact will the coming era of financial deleveraging and decelerating growth have on Chinese politics?

Most would suggest that a period of financial retrenchment and slow GDP growth poses a serious threat to the legitimacy of the Chinese Communist Party (CCP), which is based on economic performance. Rising unemployment could spur social unrest. The middle class might turn against the party. Because economic distress harms different social groups simultaneously, it could facilitate the emergence of a broad anti-CCP coalition.

Moreover, massive economic dislocation could destroy the cohesion of the ruling elites and make them more vulnerable politically. Indeed, members of the ruling elite will be the most immediately affected by financial deleveraging. Those who borrowed recklessly during China’s credit boom are not small private firms or average consumers (household indebtedness in China is very low), but local governments, SOEs, and well-connected real estate developers (many of them family members of government officials). Technically, successful financial deleveraging means restructuring their debts and forcing some of them into bankruptcy.

By definition, such people have the political wherewithal to mount a fierce fight to preserve their wealth. But, given the huge size of China’s credit bubble and the enormous amounts of money needed to recapitalize the banking system, only some of them will be bailed out. Those who are not will naturally harbor resentment toward those who are.

Slower GDP growth undermines elite unity according to a different political dynamic. The current Chinese system is a gigantic rent-distributing mechanism. The ruling elites have learned to live with each other not through shared beliefs, values, or rules, but by carving up the spoils of economic development. In a high-growth environment, each group or individual could count on getting a lucrative contract or project. When growth falters, the food fight among party members will become vicious.

The people who should be most concerned with financial deleveraging and slower growth are President and CCP General Secretary Xi Jinping and Prime Minister Li Keqiang. If the deleveraging process is quick and orderly, they will emerge stronger in time for their reappointment in 2017 (the Chinese political calendar thus dictates that they turn the economy around by the first half of that year).

Xi and Li are inseparably linked with the CCP’s promise of economic prosperity and national greatness, embodied in the official catchphrase, “China dream.” What, then, will they do when faced with a political nightmare?

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    1. CommentedWong Hoong Hooi

      Japan had, for more than a decade, the ingredients which the article writer says will produce disaster for China:
      a. Huge debt
      b. Stagnating economy
      Of course, the stock answer in Western opinion circles is that Japanese society is too disciplined to let the country descend into chaos; just as the stock prediction for China is that economic slowdown will lead to social unrest and loss of legitimacy for the CCP. We need closer objective fresh analysis and not articles written on the basis of the same old stock answers.

        CommentedYoshimichi Moriyama

        China has one advantage that Japan lacks. It is in Dr. Pei's words "the regime's enormous capacity for repression." (

    2. CommentedLeo Arouet

      Como siempre Minxin Pei con los análisis agudos sobre la política económica de China. Por lo visto, en ese país asiático podría darse una dura recesión como se dio en Occidente. Los líderes chinos deben asumir su papel de tecnócratas eficientemente para poder salvar su economía y sociedad. Por lo demás, la clase media del mundo va a estar a un paso del desborde democrático.

      Buen artículo.

    3. CommentedProcyon Mukherjee

      The bulk of the debt is held by the Government in China, of which the Central Government, is clearly at a solvent position with 3% of fiscal deficit, at the most. It is the local government which is under pressure as the major source of revenue which is land is no more 'saleable' in the same pace as before. The worrisome factor is the price of land which has outpaced the growth of property prices by a factor of 2 and is clearly nearing the tipping point, this would make the local government balance sheets come under stress.

      The debt to revenue ratio of the local governments would determine the pace of infrastructure projects in the future and should be the key statistic to watch out.