BEIJING—There is no better metaphor for the economic challenge facing China than the futuristic architectural masterpiece designed to house the country’s state television network, CCTV. A few months before the landmark building was to be completed in 2009, officials at the network conducted an unauthorized fireworks display, sparking a fire that consumed a smaller building in the complex, a wedge-shaped tower that Beijing’s residents had nicknamed the Termite’s Nest.
The fire delayed the completion of the CCTV headquarters until 2012. The Termite’s Nest remains unfinished and unoccupied; its structural integrity was destroyed in the fire, and it cannot be torn down for fear of undermining its bigger neighbor. The good part of the structure cannot shake off the burden of the bad.
The two buildings recall China’s increasingly two-tracked economy: a new track based on services and consumption burdened by an old, slower track made up of industries like steel and mining, which are inefficient and suffer from excess capacity. Straddling both tracks is the country’s real estate market, which is characterized by massive overcapacity in mid-size and smaller cities, and robust demand in large cities.
The problem is compounded by the Chinese leadership’s insistence on sticking to high growth targets—7 percent at present—and the resulting reliance on credit to produce the requisite output. Because the credit system has been designed around implicit state guarantees, much of the financing is misallocated to the economy’s less efficient, highly indebted sectors. As a result, the foundations of China’s growth miracle are steadily being eroded by a debt overhang that shows few signs of receding.
The government’s loss of control over the economy has become increasingly evident. The meteoric rise and subsequent crash in the country’s stock market has left investors badly rattled. But the real wake-up call has been the belated effort to sort out local government borrowing and misspending.
The National Audit Office’s first attempt to estimate the size of local government debt uncovered a stock worth 26 percent of GDP at the end of 2010. A second effort in mid-2013 revealed a further rise to 32 percent of GDP. And the latest study by the Chinese Academy of Social Sciences shows that the debt jumped sharply, to 47.5 percent of GDP, by the end of 2014.
In November 2013, President Xi Jinping laid out a reform agenda that sought to increase the role of the market in China’s economy. This, it was hoped, would solve the capital misallocation problem that seemed to be leading to an unsustainable rise in debt.
Local government debt became a major test case. In early 2015, the central government announced plans to convert the local governments’ short-term, high-interest bank loans into long-term bonds. By increasing the maturity of the debt, the central government hoped to alleviate financing constraints on local governments and allow them to pursue financial stimulus.
When China’s banks balked at accepting the low yields offered on the new bonds, the goal of increasing the market’s role in the economy went out the window. The government forced banks to execute the debt swap. Unsurprisingly, banks suddenly became risk-averse. Local governments discovered that even with an improved liquidity position, banks were reluctant to extend new loans.
Meanwhile a slump in the real-estate market deprived local governments of their main revenue source: land sales. Thus ensued one of the more shocking developments in modern Chinese economic policymaking: the government’s call for stimulus was simply ignored.
China appears to be falling into a trap that it assiduously sought to avoid. The country’s debt problem looks set to worsen as the government neglects its reforms in favor of short-term growth objectives. The drag on the economy will increase as resources continue to be diverted toward keeping inefficient firms alive. Banks will become ever more risk-averse as they seek to hide bad debts and avoid write-downs.
The government has sought to increase liquidity by dropping controls on the movement of capital. Doing so not only further undermines its control of the economy; it also creates the risk of a full-blown financial crisis that could engulf its neighbors and other emerging markets. For the moment, with the rising dollar adding to China’s economic woes as its currency appreciates sharply against regional peers, the authorities have fallen back on old instincts by devaluing the currency.
That will not be enough. China’s property market is deflating. Its equity markets have been discredited. And its economy seems increasingly sluggish. As a result, the country’s vast pool of domestic savings is increasingly looking to move abroad. Relative to the size of China’s foreign debt and the sheer volume of money that could go abroad, even its $3.7 trillion in foreign reserves starts to look puny.
Like termites, debt has a unique capacity to make short work of an economy’s foundations. By the time the infestation is recognized, it is often too late. If China is to reverse the damage, it will need to focus on debt deleveraging, repair its capital allocation mechanism, and delay the abolition of capital controls. The country’s economy is likely to suffer a growth crisis within the next 12-24 months. Its severity will be determined by whether the government makes difficult adjustments today or—like Japan in the 1990s—tries to wish the termites away. Project Syndicate
Gene Frieda is a global strategist for Moore Europe Capital Management.