Australia’s economy is being sustained by a credit boom in China that the International Monetary Fund warns is bound to end badly.
The fund’s hard-hitting review of China’s economy says there is no international precedent for such a large credit boom culminating in anything other than a sharp downturn or a financial crisis.
The fund’s loss of confidence that the Chinese authorities will act to rein in the runaway debt growth has led it to upgrade its growth forecasts for the next three years from an average of 6 per cent to 6.4 per cent.
“The baseline implies ongoing support for global commodity exporters which benefit from strong public investment, real estate and heavy industry (such as Brazil and Australia),” the fund says.
“But this scenario of high growth and high debt accumulation also raises the probability of a disruptive adjustment to Chinese demand that would result in a sharp contraction in imports and a contractionary impulse to the global economy,” it says.
The Reserve Bank largely shares the IMF’s concerns. At the recent parliamentary hearing, deputy governor Guy Debelle said no country had ever gone through a period of financial deregulation without experiencing some disruption.
“Maybe China will be the first, or maybe not, and that remains to be seen,” he said. Although Chinese authorities were strengthening regulation of some aspects of the financial system, it had so far had no effect on the overall economy, with debt levels still rising.
“Will that eventually come unstuck, I think, is really the open question. It is one we’re paying a lot of attention to, and it is a material risk out there for both the Chinese economy and the rest of the world,” he said.
Australia’s exposure to the Chinese economy has increased dramatically over the past decade, with its share of Australia’s merchandise exports rising from 13 per cent to 33 per cent in that period, while the growth of tourism and education have made it also the largest source of services export income, accounting for 16 per cent.
The continuing support which China’s economy is bringing to Australia is highlighted by the renewed strength of commodity prices. Chinese steel prices are rising in response to strengthened demand, and this is flowing through to both iron ore prices, which are back above $US75 a tonne, and coking coal, which reached $US200 last week
In its response to the IMF’s formal Article IV report on its economy China accepted the upgrade to the growth outlook but rejected the fund’s view of the risks.
“We are confident in sustaining the growth momentum and an abrupt slowdown is very unlikely,” China’s representative on the fund, Jin Zhongxia, said.
“The stronger performance since 2017 was not merely driven by policy stimulus, but rather, a reflection of rebalancing and structural adjustment, supported by a rebound in the business cycle against the backdrop of a stronger global recovery,” he said in the formal response to the IMF’s report.
The IMF has long been concerned about China’s credit growth, but is basing its stark warning on new empirical work examining 43 previous credit booms from around the world. The sample was selected from countries where credit had risen by more than 30 percentage points of GDP over a five-year period.
The IMF estimates that China’s non-financial credit to GDP rose by 60 percentage points of GDP in the five years to 2016, reaching 230 per cent of GDP. Unless something is done to check the growth, it will rise further to 290 per cent of GDP by 2022.
Only five of the booms in the IMF study had ended without a financial crisis, a sharp growth slowdown or both immediately afterwards. The IMF said the five exceptions should “provide little comfort” to China as there were particular circumstances in each.
New Zealand’s boom at the end of the 1980s was off a very low base while Hong Kong’s boom in 1983 reflected its role as a global financial centre. Finland had a boom in 2003 that was really a recovery from a large debt reduction in the late 19990s, while credit booms in Indonesia an 1990 and in Switzerland in 1985 eventually led to crises.
“All credit booms that began when the ratios were above 100 per cent — as in China’s case — ended badly,” the fund said.
“International experience suggests that China’s current credit trajectory is dangerous with increasing risks of a disruptive adjustment and/or a marked growth slowdown,” it says.
The IMF analysis highlighted potential triggers for a financial crisis. The rapid credit growth has relied on complex funding structures extending beyond deposit funding to wealth management products and short-term interbank markets. The use of interbank funding increases the risk of problems in one institution spreading to the financial system.
The second potential source of shock could come from a loss of confidence in the short-term asset management products issued by non-bank financial institutions or from a run on the wealth management products that fund them.
The fund says China is extracting diminishing returns from its credit growth. In 2007-08, raising nominal GDP by 5 trillion yuan ($1 trillion) was achieved with the addition of 6.5 trillion yuan in credit. But in 2015-16, it took an additional 20 trillion yuan to achieve the same result.
The fund calculates that China’s growth rate would have averaged 5.3 per cent over the past five years, rather than the actual 7.3 per cent were it not for the excessive credit growth.
The fund anticipates objections to its view of the risks. Many argue that China is insulated from a crisis by its strong external position and the fact that its debt is mainly funded domestically.
However, several countries had credit booms that “ended badly” despite running current account surpluses, including the savings and loan crisis in the US in the 1980s, Japan’s banking crisis in 1997 and the US and British crises in 2008.
“If financial institutions are expanding their balance sheets by relying on short-term funding amid ample liquidity, a funding squeeze could trigger a downturn/crisis,” it says.
The IMF does not think China’s high savings rate, which results in large bank deposits, will help. Loans are only about 20 per cent larger than deposits, which is well below the level of many other countries that experienced crises. However, the IMF says China’s position is made worse by large securitised assets that are weakly regulated and which are far higher than in other countries that suffered crises.
The fund does not believe the government has the budget latitude to forestall a crisis, rejecting the official estimate that government debt is only 40 per cent of GDP.
Including off-balance sheet liabilities, the IMF estimates government debt at 90 per cent of GDP and says government borrowing is “on an unsustainable path.”
The IMF called on the Chinese authorities to abandon their GDP targets and the credit growth required to hit them.
China’s Jin Zhongxia said the growth targets were not rigid. He said the debt build-up was manageable, particularly given the high level of Chinese savings, and would slow as reforms took effect.
By DAVID UREN