Beware a Credit Fueled Economic Expansion

Moody’s investors service just downgraded China’s credit rating from Aa3 to A1. Bloomberg notes that the last time they downgraded Chinese debt was after the Tiananmen Square crackdown and just before the Berlin wall fell. That was 1989 and today’s gleaming financial center in Shanghai was still a swamp.

Moody’s latest downgrade to A1 from Aa3 Wednesday comes as President Xi Jinping pushes China’s influence around the world. That was highlighted by this month’s gathering of global leaders in Beijing to celebrate a multi-billion dollar infrastructure-building initiative along the old Silk Road that Xi describes as the “project of the century.”

China has since become an economic colossus, contributing about one third of global growth last year. It’s on track to expand at an estimated 6.6 percent this year.

But it’s been a credit-fueled expansion. And that’s what’s got Moody’s worried.

The key to China’s success over the last decades and the key to its current problem is debt fueled growth. Interestingly in 1989 Japan’s shot at world economic domination fizzled out when massive hidden loans came to light. Heavy debt led to a stagnating economy in Japan for that last two and a half decades. Will China’s credit fueled expansion end up the same way?

What’s Next?

Private debt in China was 100% of the GDP in 2008 on the eve of the Great Recession. It is 150% of the GDP today. Banks in the land of managed capitalism could be in big trouble. In fact, Business Insider suggests that a massive bank bailout in China may be necessary.

China’s leaders have identified the containment of financial risks and asset bubbles as a top priority this year. All the same, authorities are moving cautiously to avoid knocking economic growth, gingerly raising short-term interest rates while tightening regulatory supervision.

At the same time, Beijing’s need to deliver on official growth targets is likely to make the economy increasingly reliant on stimulus, Moody’s said.

“While ongoing progress on reforms is likely to transform the economy and financial system over time, it is not likely to prevent a further material rise in economy-wide debt, and the consequent increase in contingent liabilities for the government,” it said.

In order to continue to provide jobs and maintain domestic tranquility China will need to keep borrowing. And that is would could take China down Japan’s path and require bank bailouts and more.

The Debt Addiction

The New York Times writes that China’s debt addiction now threatens its growth.

China has gone on a spending spree, borrowing money to build cities, create manufacturing giants and nurture financial markets – money that has helped drive the economic powerhouse in recent years. But the debt-fueled binge now threatens to sap growth in the world’s second largest economy.

With its economy maturing, China has had to pile on ever more debt to keep growth going briskly, a pace that could prove unsustainable. And the money is increasingly flowing through opaque channels that operate outside the regulated banking system, leaving China vulnerable should those hidden risks blow up.

The Times also notes that economists are comparing China’s situation with Japan’s at the end of the 80’s. The problem for China is that Communist Party maintains its control of the country today as much by driving economic growth and providing jobs as it does by using police state tactics. The Communists running China don’t want to lose their positions so it is likely that borrowing and spending will continue until the credit fueled expansion is totally unsustainable.