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China is betting billions in stimulus on industrial projects that may never pay for themselves. If that bet goes wrong, it won’t just rattle China’s economy, it will rattle the world’s economy.
There are many things that are reported to worry global investors today, such as the United States’s (US’s) budget deficit and debt, trade tariffs, climate change, and the war in Iran. One that should perhaps worry them most is the intersection between China’s economic growth rate and its deficit.
The chart below shows China’s economic growth rate since the 1980s, alongside that of advanced economies and the global average.
Over time China’s growth rate began to slow to average 4.6% over the past five years. That in itself is not a problem, because an economic growth rate of 4% to 5% is still very strong, and it comes on top of the high growth rates of the past 40 years.
The chart below provides a view of the shorter-term trend for Chinese growth, compared to that of advanced economies and the average for the world. It does so by taking five-year average growth rates from 1997 all the way into the present.
Just from a straight-up growth perspective, therefore, there is nothing in the official Chinese growth data to indicate a problem.
The worry only begins when reading China’s growth rate against its budget deficit. A budget deficit measures the difference between what a government receives in revenue and what it spends. When the government spends more than it receives, it must borrow to cover the difference.
As China’s economic growth rate slowed, its deficit has increased, as is visible in the chart below.
A deficit is not in itself a problem. A country can incur a deficit in order to invest in infrastructure and the like that will produce future returns that allow it to pay off the debt it has incurred to finance those projects. In this sense, there is a very good argument that countries should, in fact, incur deficits.
At this stage, again, there is little in the growth or deficit data to suggest reason for alarm.
The trouble only arises when you realise that there are two budget deficit figures for China. The first is the official deficit recorded by the Chinese government. The second is a series of private estimates produced by global institutions, such as Fitch.
How is it possible that there can be two budget deficits? The reason is that China records some of its state expenditure as off-budget expenditure. What it means by this is that the expenditure is not so much expenditure on state functions but rather capital invested in strategic projects. The distinction is tenuous enough for global observers of China’s economy to produce their own private estimates of its deficit.
The difference between the official and the private estimates is set out in the table below.
What immediately stands out is that the official deficit is broadly in line with the reported rate of economic growth. The privately estimated deficit is far greater than the rate of economic growth. This is where the concern arises, because there is a fear that the projects being financed will not be able to produce the returns to pay off the debt being incurred.
The chart below shows where the debt is being incurred. It reveals the types of projects being supported by debt.
What the data show is that China has been making a considerable investment in its industrial, services, real estate, and infrastructure sectors. Even where the chart suggests that the extent of those loans has been coming down, be aware the chart shows the year-on-year change in loans provided.
What is going on here is that as China’s rate of economic growth has slowed, the Chinese state has provided a singificant degree of what is called “stimulus” to shore up the growth rate of that economy. Stimulus essentially means debt created by or incurred by a state on order to subsidise its economic performance.
The question that arises from this is whether the stimulus will lead to projects that deliver the returns necessary to pay off the debt it incurs. If not, then China’s economy, and by extension the global economy, might run into trouble. The scale of that trouble can be read into the fact that China’s economy now contributes to roughly a fifth of global GDP.
In the global financial crisis of 2008, a similar but different phenomenon played out. American banks were making home loans to people without the income or assets to pay them back. What is happening in China is very much more complex than that, but a similar dynamic is at play in the concern that there is a debt problem inside one of the world’s leading and most important economies. In 2008, the American risk blew up in large part because regulators and the state could not or would not see the risk for what it was. The position in China today is very different, and the Chinese state is seized with the problem, meaning that some of the world’s sharpest and most ruthless economic and financial minds are trying to address it. Beyond that, the technological, strategic, and diplomatic successes that China is achieving provide it with extremely important geographic and geopolitical assets and markets to sustain its economy.
It would be a brave investor, therefore, who bets against China’s ability to solve the problem, and grow very strongly beyond it, but in any list of the key risks facing the global economy the issue of China’s debt and its two deficits deserves some serious thought.