Sep 16, 2014
WILLIAM PESEK
THE risk of what Nobel laureate Paul Krugman calls "Japanification" - a semi-permanent economic funk - has haunted China for at least a couple years now.
Last week, a Bank of America Merrill Lynch report again asked: "Will China repeat Japan's experience?"
Let's dispense with the suspense: Yes, China very likely will. And the outcome will have far more serious global implications than Professor Krugman's main worry, which focuses on the chances of stagnation in Europe.
China's "severely under-capitalised financial system", "imbalanced growth" and chronic "overcapacity" all remind Merrill Lynch analysts of Japan in 1992, when its bubble troubles first began to paralyse the economy.
Most worrying is the shaky banking sector. What concerns the analysts is the lack of bold action in Beijing at a time when the scale of Chinese bad debt may be higher than Japan's ever was - they believe non-performing loan ratios are "significantly into double-digit" territory.
In the first half of this year, the analysts estimated that commercial banks had to book larger non-performing loan liabilities than for all of last year.
As recently as July, total social financing, a proxy for debt, was still growing by almost 16 per cent year-over-year, a rate well above China's nominal gross domestic product (GDP) growth. In other words, China has spent much of this year adding to its debt and credit bubbles - not curbing them.
China passed the point of no return after the crash of Lehman Brothers in 2008, when it unleashed a US$652 billion (S$825 billion) stimulus package, followed by untold smaller ones.
If Beijing were to attempt a broad credit shakeout now, virtually every sector of the economy would suffer. The risks of social unrest would soar.
China may soon face the dilemma Japan did in 1997, when 100-year-old Yamaichi Securities collapsed and threatened to turn the Asian Financial Crisis into a global meltdown.
Japan raced to prop up its banking system with bailouts and interest-rate cuts. The Japanese response shoved the country into the infamous "lost decades".
The popular tonic is that China has US$4 trillion of currency reserves to toss at its bad-loan problem. Yet any move to turn China's United States Treasuries, European debt and Japanese bonds into cash could precipitate a global rout.
A Chinese crash would hammer commodities markets, industries from manufacturing to high tech, and the sovereign and corporate credit ratings of export-reliant economies from Australia to Japan to Brazil. It would be an untimely blow to the US and an increasingly fragile Europe.
Yet Chinese banks continue to open new credit spigots. Last month, new local-currency loans grew to US$114 billion, compared with US$63 billion in July.
And with China now recording the weakest industrial-output figures since the global crisis, economists like Liu Li-Gang of Australia And New Zealand Banking Group are betting on fresh rounds of stimulus to ensure China hits this year's 7.5 per cent growth target.
China should instead allow deleveraging to begin immediately. While the government has allowed some small debt defaults, it has yet to permit a big one that would chasten lenders. It is going to have to stomach some bigger defaults.
Leaders need to direct the central bank to drain credit and clamp down on the shadow-banking monster that has grown exponentially since 2008.
Alas, China shows no signs of engineering such a purge. As Japan proves even today, healthy growth depends on a functioning and stable banking system.
The longer China waits to create one, the more it courts the kind of lost decade the world economy can scarcely afford.
BLOOMBERG
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