Toxic mixture: China faces major challenges

Xi, China’s man of power, is now even more powerful. A few days ago, he was unanimously confirmed in office for another five years by the Chinese National People’s Congress. Prior to this, parliament had lifted the restriction for presidents to two legislative periods. Xi, however, is braced for an extremely difficult term of office. He must be careful that China does not become the next Lehman case.

One example of the current difficult situation is the consequences of the one-child policy, which is becoming more and more dramatic. The country could be left with an overaged population. According to a report by the Beijing-based China Renmin University, the Chinese working population aged 15 to 59 has declined by 20 million people in the last five years. The researchers expect the working population to shrink from its former peak of 925 million in 2011 to 700 million by 2050.

China is making great efforts to boost its economy. The country wants to move away from being a production location to an innovation location. This transformation will be accompanied by a deceleration in growth momentum. Overall, though, only a small section of the population will benefit from this change.

This could become critical, because the high popularity of the party and the government in China is based on the growing prosperity of large sections of the population. In line with this, China is also making preparations for a change to its growth model. Digital control is to be extended to a kind of digital dictatorship. At the same time, the powers of the Communist party’s anti-corruption unit are being greatly expanded. This will make it possible to detect, suppress or even prevent emerging criticism or resistance at an early stage.

The Chinese People’s Party has lastingly consolidated its power. However, the medium and long-term implications of these political changes for economic development are unclear. At all events, a sustained positive development of an innovation-driven economy in such a repressive system represents a challenge for the political system.

However, China also faces significant short-term challenges, above all the rising debt. This has already mushroomed to a dangerously high level and now poses a considerable risk to the economic and financial stability of the country. Of that there can be little doubt. At over 29 trillion US dollars, China’s debt mountain is the second highest in the world, the debt ratio of more than 250 percent is enormous for a developing economy and has surged by more than 100 percentage point in the last ten years. It is no coincidence that the IMF and the BIS have for some time now been drawing parallels with countries whose debt excesses ultimately ended in crisis: Japan in the 1980s, Thailand in the 1990s or Spain after the turn of the millennium. China could also be heading for such a crisis.

An especially critical point is the high level of debt in the corporate sector, which at over 160 percent of gross domestic product (GDP) is unparalleled worldwide. Lying behind this are considerable volumes of unsound, „hidden“ national debt. By this I mean state-owned companies with debt levels around twice as high as that of pure privately-owned enterprises. However, the profitability of these companies is close to zero.

These companies are industrial enterprises that would have been insolvent long ago without the subsidised loans from the state banks. However, they are kept artificially alive by Beijing. This area also includes dubious special purpose vehicles that have raised loans on behalf of provincial governments. And on top of all this is the property market that is completely overpriced. If the bubble bursts here, large parts of the economy would be affected, as almost half of all loans are directly or indirectly related to the real estate market.

All this is a toxic mixture: It is difficult to predict whether – let alone when – China might actually slide into a crisis. However, the risk is anything but small. Ultimately, a whole wave of loan defaults could be unleashed by a correction in house prices, an economic downturn, but also the collapse of a major corporation.

So what does this mean for the global economy? There is much to argue against the claim that China is threatened with a second „Lehman moment“, as is sometimes feared. Beijing should have a good chance of averting a systemic financial crisis: The financial strength of the central government is high, its debt is moderate at less than 50 percent of GDP and it is hardly dependent on foreign creditors. It could sufficiently capitalise the banks and also absorb private companies, such as the Anbang insurance group, and would probably do so.

The risks of contagion for the global financial system also seems to me to be manageable, because Chinese banks have few international crosslinks. More problematic are the numerous global shareholdings of highly indebted Chinese companies, such as the completely impenetrable HNA Group. Were these shareholders to experience financial difficulties, companies in Germany in which Chinese investors hold stakes could also come under pressure.

On all accounts, China’s economy is unlikely to withstand the impact of possible shocks in the banking sector, and this would then be felt worldwide. The debt problem in China therefore represents a very considerable economic risk – and not only for the country itself. The world economy, that is currently ticking over quite nicely, could also be knocked off course by this.

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