World in focus

print this articlechange text size

Credit bubble?

March 4th 2010With most developed economies struggling to grow, China's stimulus-fuelled recovery for the most part has been a welcome development for the world economy, helping to ensure a shallower downturn than would otherwise have occurred. But the accompanying credit binge is an increasing source of concern both for China itself and for the global economy. Will the credit boom of 2009 force China to tighten monetary policy aggressively, thus putting the brakes on other countries' recoveries? Or is China's growth surge a prelude to the inflation of a credit bubble that will wreak even more damage when it eventually bursts? The answer on both counts is probably no. The Chinese government has both the will and the resources to curb credit growth early and deal with bad loans.

The dimensions of China's credit boom have been truly extraordinary, leading some to call it the greatest monetary-policy expansion in history. Credit in 2009 rose by 31% (an amount equivalent to 33% of GDP) from the previous year, compared with an average growth rate of 16% a year since 2001. In absolute terms, credit grew by Rmb9.6trn (US$1.4trn) in 2009.

In most other countries, such a rapid expansion would be of particular concern if the amount of outstanding credit were as high as in China. At 145% of GDP, the stock of bank credit in China is already very high, above that of the US and only moderately below that of the UK. In China's case, however, the international comparison is misleading, as China relies much less on financial markets to provide capital without bank intermediation, a mechanism that is particularly prominent in the US. Just as importantly, China has an extremely high savings rate. Most savings are held in bank accounts, so the amount of money available for lending is very high.

Nonetheless, rapid expansions in credit always raise concerns because they are frequently precursors to financial crises. This was the case in 1996, for example, prior to the Asian financial crisis. In many countries, rapid lending growth also increases pressure on the central bank to tighten monetary policy. This, in turn, has often been the trigger for recessions. While less dramatic than the impact of a financial crisis, a cyclical policy-induced downturn would still have severe negative consequences both for China and the region.

Excessive increases in money and credit are often seen as a sign of inflationary pressure. However, in China headline inflation is mostly determined by food-price inflation, which can be subject to big fluctuations resulting from supply-side factors and weather conditions. For example, food prices rose rapidly in 2007 and 2008 as a result of an outbreak of "blue-ear virus", which decimated China's pig stocks. Credit growth in many other countries tends to boost inflation, as more credit flows to consumers and raises demand for goods. In China, in contrast, additional credit mainly goes into capacity-enhancing investment, which has a deflationary effect and thus offsets higher input costs.

Of course, in the recent past, credit growth in China has been relatively orderly, so there has been little risk of credit feeding through into excessive inflation. This reflects the fact that for political reasons the authorities take the threat of inflation very seriously, and will therefore take whatever measures necessary to contain inflation. As a consequence, most episodes of higher inflation in the past ten years have been the result of food-price increases due to supply-side problems in the agricultural sector, rather than the result of excessive demand. Yet this also means that whilst inflation is not as big a threat as it may appear, the risk of a heavy-handed policy response is disproportionately high.

Apart from inflation, the main concern that China's credit boom raises is that it may lead to a surge in non-performing loans (NPLs), undermining the soundness of the banking sector. Given that Chinese banks, even the biggest ones, are still learning about risk management, the control of loan distribution during the recent run-up in credit growth has probably been poor. In addition, central and local governments have exerted pressure on banks to extend loans for political reasons. Insufficient attention to commercial considerations has increased the likelihood that borrowing requests have been poorly screened. Many of the latest infrastructure projects, for example, are expected to have negative net cashflows.

All this means that NPLs will rise sharply, quite plausibly by an amount equivalent to more than 10% of 2009 GDP, over the next few years. NPLs until now have been on a long-downward trajectory, according to China Banking Regulatory Commission data. Many observers say that very low NPLs are a sign that nothing is wrong with the banking sector, but this conclusion is misguided. Indeed, it is typical for NPLs to decline sharply during a lending boom, as loan delinquency normally occurs a significant period of time after loan origination. In a boom, the relation of new loans (which are unlikely to become troubled in the near term) relative to loans that are closer to maturity (and so more likely to become delinquent) rises sharply. NPL ratios therefore plummet. In this sense, a low NPL ratio is a sign of risk, not of stability--that was certainly the case during the recent housing boom in the US.

Yet even if a lot of Chinese loans go bad, the impact on the financial sector is likely to be much less severe than that of the bursting of the credit bubble in the US and Europe. In the past, Chinese banks have generally been able to rely on the government to take over their NPLs, rather than work out the loans themselves. It is unlikely to be different this time round. Yet unlike in bail-outs in the US, the UK and Europe, the Chinese government will not demand that the banks pay back bail-out funds. This means that any problems will not weigh heavily on the banks' ability to lend for a prolonged period. The most important difference with the US and Europe is that the government can afford such bail-outs. Its official debt stood at an estimated 17.7% of GDP in 2009—although this excludes a lot of extra-budgetary liabilities held by the central, provincial and local authorities (actual debt might be closer to 60% of GDP). Even though the true fiscal picture is therefore not as strong as headline figures indicate, China’s rapid trend rate of GDP growth means that it will easily be able to keep debt at a manageable level, and fiscal sustainability is not a near- or medium-term worry. Adding to China's ability to manage an upturn in bad loans is the government's manipulation of interest rates to give banks a wide spread; this increases profits and enhances their ability to write off bad debt.


Overall, this means that the main difficulty for China—and a source of financial and macroeconomic risk—will be to strike the correct policy balance. To support economic growth, the government will want to keep the (still fairly generous) credit-growth target for 2010 intact, while avoiding a further build-up of NPLs. Given that Chinese financial markets are still only moderately efficient, not all of that likely tightening has already been discounted. Nor have players in the real economy—corporations and households in particular—anticipated it. That means that the coming tightening measures will certainly add some volatility, and will have a slight negative impact on economic growth in 2011. However, this will not lead to a substantial downturn.