January 17, 2017
2017 will be a fascinating year for China watchers, to risk understating a growing confluence of turbulence confronting Beijing. China’s intensifying debt problem and its impact on the world’s second largest economy is perhaps the most pressing issue for President Xi Jinping and the CCP leadership. A close second is Xi’s ongoing and somewhat unpopular power-consolidation effort ahead of the 19th CCP party congress this fall. And if that weren’t enough, Beijing woke up on 9 November facing the real prospect of an incoming U.S. administration posturing to seriously challenge China on trade, Taiwan, the South China Sea, and other highly sensitive issues.
- China’s debt problem is serious, as the IMF has signaled several times. Its corporate debt stands at over 190% of GDP, and the price of deleveraging gets worse the longer the government delays structural reforms.
- China’s reluctance to tackle this problem stems, in part, from the Chinese Communist Party’s tethering its legitimacy to economic growth. Painful structural reforms could slow the economy faster than the regime feels social stability could tolerate.
- China’s strategy of using foreign exchange reserves and capital controls to keep its currency stable may become untenable in the near term. This could force Beijing to freely float its currency.
- China’s non-performing loan rate is likely much higher than the government’s official estimate, and the country does not have a legal system adept at handling widespread bankruptcies.
- President Xi is in the process of a major power-consolidation effort, and this year he and his supporters will be exceptionally sensitive to domestic discontent. They therefore may more recklessly indulge in Chinese nationalism to avoid being blamed for domestic problems. Likewise, Xi cannot be seen as weak in dealing with the new U.S. administration.
THE BALLOONING DEBT PROBLEM
Perhaps the biggest threat to the global economy this year comes from China’s worsening debt problem, a problem the incoming U.S. administration’s Asian trade policies (as stated thus far) will probably exacerbate. While Chinese public debt seems to be in check, according to Bloomberg corporate debt stands at over 190% of GDP, an alarming figure by any standard. As Richard Vague wrote in The Atlantic Monthly two years ago, “if the ratio of private debt to GDP is at least 150 percent, and if that ratio grows by at least 18 percent over the course of five years, then a big crisis is likely in the offing.” In addition, the credit-to-GDP gap, defined as the difference between the credit-to-GDP ratio and its long-run trend, stands at 30.1, higher than basically any country at any time, according to the Bank of International Settlements.
Most of the corporate debt exists in the heavy industry, utilities, and building materials sectors that depend heavily on real estate development. As the value of the Yuan continues to slide, however, the domestic real estate market is sagging and in danger of a significant contraction. Furthermore, China has blown through nearly $1 trillion in foreign exchange reserves in the last two years trying to defend the Yuan (CNY) to keep it stable in the trade-weighted exchange basket and prevent massive capital flight, a spending pace it simply cannot sustain. China appears to have started implementing capital controls in November 2016, and it is not unthinkable Beijing will soon simply give up this strategy and try to stem large scale capital flight by free floating its currency.
In the past President Xi Jinping has vowed not to float China’s currency, and the Chinese Communist Party (CCP) has always been loath to yield complete control of its currency to the market. But Donald Trump’s election victory and threatened anti-China trade policies could give Xi the political cover to change course. The major risk of doing this, of course, is that the market-clearing rate of the Yuan may prove to be lower than Beijing is counting on. China today is not the China of 15 years ago. It now has a thriving upper middle class, so while a weak Yuan will help Chinese exports compete, it will hurt a more politically connected class who enjoy the ability to educate their children overseas and other luxuries a stronger currency makes possible. A weak Yuan will also inhibit the government’s attempt to move the economy away from being so heavily export-driven, and more towards an economy of services and higher domestic consumer demand.
Furthermore, according to rating agency Fitch, the amount of non-performing loans (NPLs) in Chinese banks is ten times the official figure, or somewhere between 15% and 21% of outstanding credit, much higher than the official figure (1.8%). Capital flight from an economy with a heavily leveraged industrial sector and a serious NPL problem is a particularly toxic combination. Beijing has contributed to this problem by propping up poor performing industrial companies for years, in part to further nationalist aims and in part to maintain an outsized growth target.
So now Xi faces a worsening dilemma – sincerely attempt to deleverage on a large scale, which according to Bloomberg could put up to 8 million Chinese out of work, or nibble at the margins while hoping it can grow its way out of the problem. Deleveraging will slow the economy down more quickly and risks social instability on a scale not seen since 1989. On the other hand, hoping to grow its way out of the debt problem looks increasingly delusional, as many of China’s main trading partners have their own debt problems. Delaying serious reforms is also steadily elevating the risk of a financial shock, similar to crises that hit smaller Asian countries in the 1990s. China is not a small Asian country, however. It is the second largest economy in the world, and a financial crisis there could be contagious. In short, there are no easy choices for China.
POWER AND NATIONALISM
This is all happening against the backdrop of Xi’s ongoing consolidation of power, which very well may culminate this fall at the 19th party congress where perhaps two-thirds of the Politburo’s supreme standing committee will be replaced. During October’s Communist Party plenary session, Xi was designated the “core” leader, a title previously held by only three prior leaders including Mao Zedong and Deng Xiaoping. Justified in part by Xi’s anti-corruption campaign, the ongoing power consolidation will not only give Xi a freer hand at dealing with China’s underlying economic problems, it will allow him to more forcefully direct the national security apparatus in responding to a more antagonistic United States. And a leader trying to consolidate power is more apt to respond boldly to foreign challenges.
For at least the last thirty years, the Chinese Communist Party has tethered its political legitimacy in part to economic growth. While it is starting to message internally that inevitable slower growth has begun, economic pain often leads authoritarian regimes to stoke nationalist tensions, giving the people an outlet to place blame elsewhere. How such a deflection will manifest itself is unknown. But the incoming Trump administration appears intent on fanning the flames, giving an ever powerful Xi the perfect target. The first spike in tension may come in the South China Sea in the first 100 days of the Trump presidency, given comments his Secretary of State nominee made in his confirmation hearing about preventing further Chinese access to disputed territory there. In any event, a regime growing more worried about the country’s economic health will likely be less restrained in responding to perceived challenges to its sovereignty. Geopolitics in Asia for some time now has been centered on the trajectory of China, and 2017 will certainly make that ever more apparent.
ANKURA CONSULTING has a dedicated Asia team of geopolitical expertise to help clients better understand the risks and opportunities in an ever-turbulent region.