China's Economic Problems Mount

Prognosticators on China's economy generally fall into two camps. One asserts that reform is still the order of the day, will be reinforced by Xi Jinping and the news leadership and growth continue at the 7-8 percent level which the party expects.

The other sees China headed for crisis as export growth slows to a crawl, debt of state enterprises and, more especially, the debts of the entities set up by provincial and local governments and invested in unviable ventures cause a crisis in the banking system similar to that which ravaged the economies of Southeast Asia in the late 1990s and the US and Europe in the wake of 2008.

But there is a third and increasingly plausible way of looking at the situation, China's boom will end "not with a bang but with a whimper" perhaps even replicating the Soviet Union from the mid-60s or Brazil at the same time.

Estimates of total domestic debt in China vary, as do those of its composition. But for argument's sake we will take those of UBS. It calculates total non-financial debt at 210 percent of GDP, with central government at a relatively modest 14.8 percent, local government at 32 percent, the Railways Ministry 5.3 percent and Asset Management Company bonds (those issued to bail out the banks after their last crisis) 2.7 percent. Most debt is bank loans at 129 percent with lesser amounts in corporate bonds and estimated off-balance sheet debt.

The total debt is not high by developed country standards, reflecting a high savings rate and in principle can easily be sustained given strong GDP growth. However, concerns exist both at the pace at which it has increased over the past three years and the quality of the investment it has funded.

Corporate profits have been falling, albeit from quite high levels, and there is every indication that local government entities, faced with demand to spur growth but facing low growth in revenues as the property boom tails off, have been resorting to borrowing in the shadow banking market. This is where the needs of the borrowers meet the demands of the cash-rich for higher returns than available from bank deposits have created the funds offering higher returns from debt mostly issued by entities of local government and property developers. Some see the present situation as a Ponzi scheme with ever increasing amounts of new money being needed to meet maturing loans and interest payments. While new forms of debt have mushroomed, equity financing remains at a low ebb, an unhealthy combination.

Falling corporate profits generally will either slow investment, perhaps leading government officials to demand even more stimulus from local governments, or to further increase in debt. As it is, cheap money - and government subsidies - have helped create excess capacity in many industries.

Rising debt, falling returns and rising corporate receivables are a recipe for, at best, a very marked slowdown in the economy. This is apparent if one looks at the reported in PMIs which are barely above the growth line even as GDP growth of 7-8 percent is touted. Wages have risen in double digits which inflation has fallen but there are limited signs of a strong consumer response.

As for exports, they are under pressure from both the strength of the yuan at a time when the dollar itself has recovered some ground and from the weakness of western markets. Neither of those situations is likely to change rapidly soon, the only positive factor on the trade side being the fall in import commodity prices and the gradual rise in the value-added of manufactured exports which to some extent offsets the loss of low-end business to Vietnam, Bangladesh and elsewhere.

However, even assuming that global conditions do improve and commodity prices weaken further and sustain a strong trade balance, other problems will continue to burden China. Firstly, there is now no growth in the labor force so GDP gains must come from productivity. But even assuming that labor productivity can continue grow at 6-7 percent - and that is getting more difficult as the rate of urbanization slows due to demographic factors - falling productivity of investment will be a drag. That looks set to get worse before it gets better. Most of the cost to the economy of wasted investment lies ahead.

In other countries this would result in a banking crisis and, most likely, a foreign exchange crisis similar to the Asian experience in 1997/99. But this cannot happen in China for two interrelated reasons. Firstly the banking system, official or shadow, is still largely state-owned and its clients mostly state-related entities. Thus ultimately the central government, itself in a strong fiscal position, will provide whatever bail-outs are needed. Second, China's foreign exchange reserves are so large there can be no foreign exchange crisis, nor use of a devalued exchange rate to boost exports.

There are other issues such as environmental degradation which will impinge on growth at some point. Meanwhile some efforts to reduce pollution, such as investment in wind farms, has a very high cost. There are ways out of the problems China faces. The most important is enterprise reform which gives dynamic, particularly private, sector room, ending the ability of local governments to waste money by depriving them of access to cash, and cutting the bloated major quasi-monopolistic state enterprises down to size. There is also an urgent need for market-based interest rates which would provide a real return to households and impose more discipline on borrowers.

In short it looks as though China's growth will continue to slow. There will be no crisis but it will cease to be the "miracle" and find itself in the middle of a pack of upper middle income countries, growing at 3-4 percent a year and, after a period of angst, probably able to live with that. But meanwhile expectations are running way ahead of reality and there will be a political price to be paid for that.