Chinese credit crunch

By Mauro Guillen, Emilio Ontiveros

Economies are like bicycles: they get into trouble for going either too slow or too fast. It is hard for an economy to sustain high rates of growth if private credit does not follow suit. This is especially true if the construction sector is a major contributor to growth. The cases of the U.S., Ireland and Spain during the crisis illustrate this problem, and now China has become yet another example. Since 2009 credit has expanded much faster than GDP, and real-estate prices have grown even faster. Still, the Chinese economy does not follow the usual pattern, in ways that actually add to the sense of alarm about the future of the world's second-largest economy.

The most problematic feature of recent economic developments in China is that most of the credit expansion over the last four years comes from the shadow banking sector, i.e. financial intermediaries not supervised by the authorities. Analysts and investors are right to be concerned about this. A few weeks ago banks ceased to lend each other in the wholesale market, signaling the beginning of a credit crunch. On June 20 the inter-bank interest rate reached 25 percent, and bank shares took a hit. While the central bank played a role in making credit more expensive by refusing to lend, it was a difficult moment in which banks were approaching the end of the second quarter.

Another unique Chinese feature is that its financial system is not dependent on external financing. The domestic savings rate is much higher than in Europe or the United States. Moreover, China enjoys a large current account surplus. China has at its disposal considerable degrees of freedom.

Still, the consequences of a credit crunch in China could be devastating, especially in the informal financial sector. Many small and medium enterprises depend on unconventional credit channels for survival. Clearly, monetary authorities are not likely to allow high rates of credit expansion. Investment will decline, and it has recently accounted for nearly half of GDP.

Chinese financial problems are likely to spill over into other parts of the global economy. Even if deleveraging takes place in an orderly and gradual way, Chinese GDP growth will suffer. This will in turn affect countries that export to China, especially Japan and South Korea. It may also prove devastating for exporters of commodities, especially Brazil.

The timing of China's reckoning with its recent credit expansion could not be worse. The Federal Reserve has just signaled that quantitative easing may come to an end. Financial markets around the world are reeling.

Uncertainty is on the increase, not only because of the continuing problems in Europe but because of the slowdown in emerging economies. Unfortunately, China's financial system is now adding to global financial woes.

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