China’s economic growth will slow significantly over the next decade. One of the most important drivers of this slowdown is the unwinding of an unprecedented credit bubble. China’s financial system simply won’t be able to generate the same levels of credit growth that it has in previous years. This means that Beijing will have far less control over the direction of its economy than it has in the past. Growth in total societal financing (TSF), a measure of funds provided by the financial system to the real economy, is at all-time lows, and other credit metrics are decelerating. Over the next decade, we expect rates of credit growth in China to fall below 10%, with knock-on effects for investment growth and the broader economy. Credit growth is under pressure for three main reasons:
- Credit demand is slowing sharply, because households and corporates have reined in their expectations for economic growth.
- Lenders are becoming more cautious in response to rising credit risks in several asset classes, as implicit government guarantees for borrowers lose credibility. This is particularly apparent in lending to the property sector.
- Credit supply is constrained by the massive size of China’s financial system, and the difficulties of maintaining high rates of credit growth while complying with regulations related to capital requirements and loan loss provisions.
Pretending Prevents Extending
China’s economy depends on investment, which depends heavily on the flow of new credit to fund that investment. Investment (gross fixed capital formation) makes up around 42% of China’s GDP, far above other economies at China’s stage of development. Savings rates remain extremely high, putting downward pressure on household consumption. Significant changes in the direction of China’s credit impulse can meaningfully change the direction of the economy and global cyclical signals, with recent research by the Federal Reserve highlighting the importance of China’s credit conditions.[1]
In the past, China’s financial system grew much faster than the real economy: credit grew by 18.1% on average between 2007 and 2016, and the banking system added $26.8 trillion in assets over that period, compared to “only” $7.6 trillion in GDP growth. Credit expanded rapidly because financial losses were unthinkable because of implicit government guarantees for both borrowers and lenders. In essence, markets assumed that Beijing would always intervene to prevent financial instability. (See Credit and Credibility for a much more detailed discussion of this argument.) This led to a dramatic expansion of China’s shadow banking system, which extended large volumes of credit to both property developers and local governments. China’s authorities did not consider moral hazard a problem. On the contrary, it was a core element of their strategy for…
Read More: The End of China’s Magical Credit Machine
