Why China won't cause a global recession

Weak Chinese economic data, gyrating stock markets and fears over the trade war have raised concerns that China will lead the world into the next recession. In my view that will only happen if China falls into a major financial crisis. A continuing economic slowdown, even to quite low growth rates, won’t be enough. More likely in fact, is that a new world recession, I would guess in 2021-22, plunges China into crisis, as its profligate debt expansion of the last 10 years finally ends in tears.

China’s economy looks set to slow further in coming months, but then probably stabilise or pick up a bit later in the year, before slowing further in 2020-21. A crisis is unlikely because the authorities still have $3 trillion in reserves and they closely control the financial system. Most of the debt is owed by state financial institutions to state enterprises. That said, each time the authorities boost the economy, as they are doing again now, they ratchet up debt ratios, making the risk of a crisis greater, down the road.

On official data, China’s GDP growth has slowed from double digits rates just before and just after the Global Financial Crisis (GFC) to an expected 6.6% in 2018. The numbers are almost certainly exaggerated, at least recently - China may well have been growing very, very fast for a while a decade ago. Capital Economics reckon the growth rate was only about 5.5% in the latter part of 2018 and is set to slow to 4% in 2019, which seems about right to me. But it doesnt look like 2008-9.

It would be difficult to account for the way the markets and analysts react to GDP figures otherwise. For example, when an official GDP number comes in at (say) 6.5% instead of the expected 6.7% the markets swoon, which only makes sense if the change is really signalling something like from 7% to 5%. A 0.2% difference in GDP growth rates is immaterial. That said, it is difficult to judge the overall state of the economy because for some years the heavy industrial sector has been weak, while the service sector has been much stronger. Still, data for several months now shows a slowdown across the board, including infrastructure investment, purchasing managers’ indices, money growth, the housing market, and retail sales.

Taking the long view, are there any lessons from history on what will happen next? It is often forgotten that Thailand enjoyed double digit growth rates for several years in the early 1990s, alongside a stock and property price boom. This was in many ways similar to the path of China’s economy from about 2005-12. Then Thailand gradually slowed amidst rising debt and a collapsing stock market, before triggering what turned into the Asian financial crisis in 1997. I reckon China’s economy is following much the same trajectory.

But I don’t see China falling into a crisis in the same way. Unlike China today, Thailand had a current account deficit and very little foreign exchange reserves, its crony capitalist government had little knowledge of the shadow banking system, let alone control, and there was a great deal of US dollar debt. When the Bank of Thailand ran out of FX reserves in July 1997, the massive devaluation bankrupted many of the largest companies. China faces the same economic slowdown and the same problem with excessive debts, but has 3 trillion dollars of reserves, a current account surplus, and limited debt in US dollars.

What about the Japanese experience in the 1990s? I think this might turn out to be closer to China’s current case. In Japan an investment boom and property bubble in the late 1980s led to a massive overhang of debt. When tighter monetary policy eventually ended the boom, the economy went into recession and then suffered 10 years of very slow economic growth as investment stayed weak. There was a financial crisis, but it was put off for many years because, unlike in Thailand but similarly to China today, the government effectively supported the financial system. Finally, when Thailand triggered the regional crisis in 1997, putting new stress on Japanese banks, the government was forced to rescue the financial system.

Again, there are some important differences. The most important is that China still has a lot of catching up to do to reach Japan’s living standards and there are plenty of industries, especially in the services area, where economic dynamism should help China to recover from a major slowdown better than Japan did. While Japan in 1990 had a world-class manufacturing sector its service sector was highly protected so there were few new sources of investment opening up. Second, the Japanese central bank was slow to respond with easier monetary policy in 1990-92, making the initial downturn worse.

Still, this points up one of the key problems the Chinese authorities face. The easiest way to deal with an economic slowdown and excessive debt is to expand the money supply and allow the currency to fall. But that will be very unpopular domestically. Remember it was high inflation in the late 1980s which led to the Tiananmen Square protests. Equally, devaluation will be unpopular abroad, not least in the White House. But if monetary policy is not eased, that leaves the stimulus burden all on fiscal policy.

The authorities cut the reserve requirement three times in 2018 and again early this year. They also announced personal income tax cuts to take effect in January. Then, at the 3-day economic conference in late December the Chinese authorities agreed on more tax cuts, together with a ‘relatively substantial increase’ in local government bond issuance to finance infrastructure.

It’s a risky strategy because the debt burden will rise further. But also, the higher debt becomes, the harder it is to push it yet higher because consumers, businesses and banks will baulk at yet more borrowing. Total non-financial debt in the economy already stood at 261% of GDP at end 2018 according to the BIS and is likely to rise further to 275% of GDP in 2019. Household debt has risen from 33% to 51% of GDP since 2013 and, since household income is only about half of GDP, (given the still very high business investment rate), this translates to a debt/household income ratio of around 100%, quite high for an emerging country. With the housing sector weak at the moment, further support for the economy from rising personal debt looks unlikely. Official government debt stands at 38% of GDP, quite modest, but the IMFs measure of ‘augmented debt’ including various off-balance sheet items and particularly local government debt vehicles, is almost double that at 72%.

Still, it remains corporate debt, up from 109% of GDP to 132% of GDP, (according to the IMF Article IV consultation report) which is the main worry. That said, most of this is lending from state banks to state companies so it is largely under the control of the authorities and is unlikely to trigger a crisis. What this high level may do, however, is limit the appetite for more borrowing and lending.

If the assets created with the debt were good earning assets it wouldn’t matter too much. But the concern is that there is still far too much over-capacity in many sectors, for example steel, cement, and glass, too much infrastructure and too many houses. Too much infrastructure is a problem no other emerging countries have (or emerged countries for that matter, except perhaps Japan). If China’s growth was really able to hold up at 6% plus for another decade China's over-investment could probably be absorbed without too much pain. But if growth (properly calculated) is going to slow to 4% this year, and then fall to 2-3% in 2020-21, as I suspect, this debt is going to overhang the economy for many years. It will be increasingly difficult for the government to pull the stimulus lever yet again. And it could produce a financial crisis. But like the experience in Japan the financial crisis is more likely to come after the slowdown than be the cause.