(WSJ) The official Chinese press recently issued a series of stories celebrating an apparent recovery of the country’s growth rate to 8%. By all appearances, China has once again deployed its enormous state capacity, including state control of the banking system, to ward off a recession. However, unlike the last major stimulus program in the late 1990s, this stimulus relies on an unconstrained credit expansion and is generating much fewer marginal benefits to the economy. Quite the opposite: Out-of-control credit expansion contains the seeds of future financial problems.
A decade ago, as now, China faced a serious economic downturn. At the beginning of 1998, growth had sunk briefly below 7% from the robust growth of nearly 9% in 1997. The trigger was the Asian financial crisis. In response, the central government first launched a 200 billion yuan (roughly $24 billion at that time’s exchange rate) rescue package for ailing state-owned enterprises in 1998, followed by investment of nearly one trillion yuan in western China from 2000 to 2003 to help maintain growth rates at 7%.
Although these programs appear similar to the current package, there are some significant differences. Most importantly, the previous stimulus was not accompanied by a spectacular increase in bank loans. Increases in lending between 1998 and 2001 never went above 20% per quarter compared to the same quarter in the previous year. For most quarters, lending increased by less than 15%.
In sharp contrast, the first and second quarters of 2009 saw credit expansion well above 30% compared to the same quarters in 2008. The reason for this disparity is that the late ’90s stimulus was under much stricter guidance from the central government. First, although the state-owned enterprise rescue plan and the Go West campaign were large for the time and in some respects not very efficient, the stimulus investment boom was kept under the relatively firm grasp of the central authorities.
In contrast, the current central stimulus package of four trillion yuan ($586 billion) is a side show compared to the 20-plus trillion yuan in investment planned by local governments. For some reason, Beijing has shown little willingness to constrain fantastical local investment plans. The National Development and Reform Commission (NDRC), previously a bastion against uncontrolled local investment, has shown nothing but great enthusiasm for approving local construction projects. The NDRC even has devised ways to allow local governments to borrow more by using long-term loans from policy banks or bond issuance as the 30% required initial capital. Local governments then can borrow the rest from commercial banks, effectively financing some projects entirely with debt.
As a result, banks are asked to finance projects with dubious commercial viability. This despite the fact that the local authorities guaranteeing construction-related loans in many cases will have a hard time repaying the debt with their own fiscal income. Unlike in the late ’90s, the central government this time has done little to shield banks from local political pressure. Instead, regulators are only asking banks to bolster their bad-debt provisions in anticipation of the inevitable rise in nonperforming loans.
Another difference between the previous package and the current one is the net benefits to the economy. In 2000, there were only 96,000 miles of expressway and well-built Class 1 and 2 highways. In 2008, after eight years of intensive building, China had 248,000 miles of higher-grade highway, an increase of more than 200%. Construction of other infrastructure has seen similar pace in the past few years. The marginal benefit of additional trillions of yuan in infrastructure investment is likely limited. Although lower-level technocrats and some government think-tanks have pointed this out, the higher authorities seem to pay little heed to the economic benefits of such a torrential pace of investment. The central government simply has approved the construction of more highways, bridges, airports and dams.
But not all the money may end up going toward infrastructure anyway. State Council researcher Wei Jianing estimates that at least 20% of the new credit has gone into the stock and real-estate markets instead of generating real benefits to the economy. This is leading to a revival of speculative investment in these markets. The Shanghai composite stock index has increased by well over 50% from the beginning of the year, while real estate prices in several major markets have climbed back near previous highs. This robust recovery took place in the face of still-declining exports and a relatively modest recovery in the growth rate. Given that result, the 20% figure may be a conservative estimate.
Should this pace of credit expansion continue for the remainder of the year, China may well face a difficult trade-off down the road. The economy is unlikely to face a financial crisis because most of the debt is owed to domestic investors and depositors and China can still prevent large-scale capital flight. However, if inflation spikes next year, the central government will have to choose between shutting off credit, which will reveal a massive nonperforming loan problem currently obscured by a torrent of new loans, or an unprecedented level of inflation. High inflation is destabilizing, as it has caused major runs on the banks before. If additional credit expansion in the face of rising inflation is not an option, the greater the extent to which lending is uncontrolled at the moment, the bigger a nonperforming loan problem the central government will face in the future.
An often overlooked ingredient to China’s success story is that generations of top-level central technocrats like Chen Yun, Yao Yilin and Zhu Rongji time and again used their political influence to constrain local investment bubbles, thus forestalling high inflation and major financial crises. Past retrenchment campaigns were unpopular and controversial, but senior technocrats nonetheless maneuvered to stop uncontrolled local investment. As credit continues to rocket toward the stratosphere, China is in increasing need of such leadership again.