Bank of Lithuania
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The prolonged credit boom in China – the world’s second largest economy – has set a “time bomb” ticking. If the policy direction remains unchanged, it may eventually explode. The consequences of this explosion would be of global scale, which means that Europe and, specifically, Lithuania would not be spared. For now, Chinese authorities have sufficient levers to keep the situation under control. However, in the longer run financial reserves accumulated may no longer suffice to cover the huge debts of state-owned enterprises and offset the losses of the banking sector. This would essentially mean the collapse of domestic public finances, pushing the country to the verge of bankruptcy.

Comment by Mindaugas Liutvinskas, Senior Economist at the Economic Policy Analysis Division of the Bank of Lithuania

China’s economy has a credit addiction

China continues to maintain its role as one of the major driving forces of the global economy. The secret behind sustained growth of China’s economy lies in large-scale credit expansion carried out through state-controlled banks and state-owned enterprises.

Between 2009 and 2016, credit growth in China ran at roughly twice the pace of GDP growth. As estimated by the International Monetary Fund (IMF), the country’s economic growth in that period would have been slower by approximately one-third if not underpinned by extensive credit growth. Even though it helped China’s economy avoid sinking in face of the global financial crisis, the ongoing credit boom may itself trigger a new wave of global crisis in the longer run.

State-owned enterprises – a growing debt burden

China has approximately 155,000 state-owned enterprises, which still constitute the backbone of the country’s economy. Between 2007 and 2014, their average return on assets dropped by almost half, lagging well behind the private sector. Deteriorated profitability indicators reflect the changed task of state-owned enterprises following the crisis – maintaining rapid growth of the domestic economy at any cost, rather than pursuing operational efficiency.

This has resulted, among other things, in a massive increase in the debt level of state-owned enterprises, which reached 115 per cent of GDP in 2015, compared to 90 per cent in 2009. A significant part of the debt stock of state-owned enterprises comes from the so-called zombie companies (in such sectors as the steel industry), which are entirely dependent on government support and credit received from state-controlled banks under preferential terms.

In case of an internal or external shock, the debts of state-owned enterprises – which borrow under implicit state guarantees – or at least their part may be ultimately transferred to the public sector. In such a scenario, public debt may cross the dangerous – given especially that China is still a developing economy – ratio of 150 per cent of GDP (currently the total public debt, including that of local authorities, exceeds 60% of GDP).

Tensions in the real estate market

The real estate (RE) sector in China has been severely affected by the credit boom. The IMF estimates that RE prices in the country’s largest cities are overvalued by at least 10–15 per cent. Over the past decade, the price level in 35 China’s metropolitan areas has risen by 17 per cent on average per year – way faster than the country’s GDP or average household income during the same period. In 2015–2016 alone, RE prices in China’s main metropolises, such as Shanghai or Beijing, shot up by one-third.

In addition to rapidly increasing prices, growing imbalances in the RE sector are also reflected by overbuilding tendencies. While the number of square metres designated for accommodation in the country more than doubled between 2011 and 2015, nearly one-fifth of the new housing units have not yet been occupied.

Risks to China’s banking sector and public finances

Chinese banks are heavily dependent on the situation in the RE market – the amount of loans issued to the construction sector exceeds one-third of the country’s GDP. This means that a sharp correction in RE prices would entail heavy losses for the financial sector. Given that virtually all banks operating in the country are state-controlled, the government would likely have no other option but to cover these losses using public resources, thus placing an additional burden on the state’s finances.

Nevertheless, alarm bells should not be set ringing, at least for the time being. Chinese authorities have, at their disposal, important levers to control the situation in the RE market. These range from control over the credit supply and state-owned land to the capacity to restrict housing transactions. Adding to this, China holds more than USD 3 trillion accumulated as financial reserves, which provides a good ‘insurance policy’. These safeguards reduce the likelihood of risks in the financial sector materialising – at least in the short-to-medium run. Notwithstanding this, the existing levers may prove insufficient to maintain stability in the longer term.

Potential impact of problems in China on the euro area and Lithuania

A crash in China’s financial sector would lead to a sharp slowdown in the country’s overall economic growth. As China accounts for approximately one-tenth of global imports, such a deceleration would inevitably have an adverse effect on the global economy. Given the existing commercial and financial ties, the euro area would also be affected. Based on preliminary assessments, the region’s GDP growth might decrease approximately by a cumulative 1 per cent within the first three years from the shock triggered by economic problems in China.

The negative impact would also be felt in Lithuania, although most probably not to a significant extent, as the commercial and financial ties between our country and China are still relatively underdeveloped. Nevertheless, problems in China could also have an adverse effect on the economy of the euro area and, simultaneously, the Lithuanian economy, through indirect channels. For instance, through reduced export opportunities to markets having close economic ties with China (such as the US, Japan or South Korea) or through heightened instability in the financial markets, which would lead to more stringent borrowing conditions.

Taking into account these risks, China needs to step up its efforts to reform the existing credit-based economic model and gradually shift towards greater reliance on domestic consumption. Otherwise, sooner or later China’s economic “time bomb” may explode, sending shockwaves across the global economy.