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China’s Balancing Act

China is now struggling with a dilemma common to all advanced credit booms: the longer the boom runs, the greater the danger of wasted investment, huge bad debts, and a major financial crisis. And, though China enjoys more room for maneuver than other countries facing similar credit booms, the risks remain serious.

NEW YORK – China’s slowdown is the biggest short-term threat to global growth. Industrial value added fell in August, credit growth has slowed dramatically, and housing prices are falling, with sales down 20% year on year. Given stagnation in the eurozone and Japan’s uncertain prospects, a Chinese hard landing would be a big hit to global demand.

Much attention is focused on likely GDP growth this year relative to the government’s 7.5% target. But the bigger issue is whether China can rebalance its economy over the next 2-3 years without suffering a financial crisis and/or a dramatic economic slowdown. Some factors specific to China make this outcome more likely, but success is by no means certain.

Faced with the 2008 financial crisis, China unleashed a credit boom to maintain output and employment growth. Credit soared from 150% of GDP in 2008 to 250% by mid-2014. Multiple forms of shadow bank credit supplemented rapid growth in bank loans.

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