The Perils of Financial Freedom

LONDON – Back in 2007, China’s then-prime minister, Wen Jiabao, famously described his country’s economy as “unstable, unbalanced, uncoordinated, and unsustainable.” Today, the imbalance remains, with the economy too focused on investment and too dependent on credit.

China’s current leadership is committed to building a more balanced model, and believes that the market must play a “decisive role” in achieving that. But, while stronger market discipline is needed in some areas, Chinese officials should be under no illusion that free markets are a panacea for the financial sector. Indeed, China’s current economic imbalances partly reflect the dangers created by competition in credit markets.

Even before the 2008 global financial crisis, China’s annual investment/GDP ratio was running at an exceptionally high 40%, and economists were calling for a transition to more consumption-led growth. But the huge credit stimulus introduced in 2009 drove the economy further in the opposite direction. The investment ratio rose to 47% by 2012, and construction now accounts for 30% of all output. Total credit has risen from 130% of GDP to 200%, with both bank loans and “shadow bank” credit expanding rapidly.

Both China and the global economy benefited from that stimulus, which helped prop up overall demand in dangerously deflationary times. But it has led to significant wasted investment in heavy industry, real estate, and urban infrastructure, and leaves China facing the challenge of deleveraging and working out bad debts.