China’s economy – the single biggest contributor to global growth – is likely slowing significantly. But you won’t find this in official estimates of GDP. According to official estimates, real GDP growth rebounded to 7.4%  annualized in 2Q18 after 5.7% annualized growth in 1Q18, with 3Q18 figures due for release this week expected to show a slight softening. The problem with the official estimates is not just their well-known – and highly questionable – excessive smoothness, but that they are akin to looking in the rearview mirror. China’s economic woes are as much domestic driven as they are by US trade tensions.

My bottom line is that, for many years, the Chinese authorities have facilitated rapid credit growth to prevent the economy from slowing. Such credit expansions typically end in a major downturn or financial crisis. The authorities are aware of this and over the last 18 months have chosen to deleverage the economy. However, now that the economy is slowing and US trade tensions are adding to its woes, the authorities have changed tack and gone back to stimulating credit, which is unlikely to end well. 

China has a large debt problem. In response to the global financial crisis, the authorities embarked on a huge fiscal stimulus and growth rebounded thanks to rapid credit growth. And, since then, to offset a slowdown in the underlying trend rate of economic growth, pretty much every time the economy showed signs of slowing the authorities pushed up credit growth further. On BIS numbers, credit to the private non-financial sector increased from 120% of GDP before the financial crisis to 210% of GDP in 2017.

By all international comparisons, this will not end well. The credit gap – the gap between credit-to-GDP and its trend – reached 29 percent of GDP in 1Q16 before moderating to 15 percent in 1Q18, still well above the 10-level that the BIS suggests is critical. The IMF identified forty-three cases of past credit booms, none as large or as long as China’s, and only five ended without a major downturn or crisis.   

Increasingly credit in China was directed towards heavy industry and infrastructure, facilitated through state-owned enterprises. As the economy ran out of efficient uses for credit, the so-called credit intensity – the ratio of the change in credit to the change in output – increased to over five in 2017, up from one before the global financial crisis.

Debt service ratios – the ratio of interest payments plus amortization to income – are now above 20 percent for the private non-financial sector. This compares to a peak of 18% in the US before the 2007 subprime crisis, and 25% in Spain before the 2007 housing crisis.

The Chinese authorities, facing a choice between deleveraging the economy in the hope of a soft landing or risking a financial crisis, appeared to have chosen the former over the last 18 months. Indeed, a variety of measures saw credit growth (measured by total social financing) slow materially over that period. As a result, economic growth is likely slowing, with a lag of 6-12 months.

There are already signs of this in the official data. Fixed asset investment growth (where previously the credit was directed too) has been easing and reached 5% yoy in August, down from 8% at the turn of the year, with a pronounced slowdown in infrastructure spending to 4% yoy, down from around 20% at the end of last year. Retail sales growth has slowed meaningfully, to around 4% yoy from 10% one-year ago.

In contrast, China’s exports have held up reasonably well so far despite the trade war with the US, but this is unlikely to last. China’s goods exports to the world increased 15% yoy in September (in USD terms) and exports to the US were up 14% yoy. But in part this likely reflects a temporary boost from front-loading of US imports of Chinese goods to avoid tariffs: indeed, vehicle exports to the US were up 21% yoy in August.

But the risk now is that, with growth slowing and the impending hit from US tariffs, the authorities will once again resort to credit to stabilise growth, at the risk of generating a bigger crisis down the line.

China’s central bank, the PBOC, has already cut the reserve requirement ratio – the reserves that banks are required to hold at the central bank – three times since March, providing more capacity for banks to lend to the real economy. And total social financing rose again in the latest monthly data.

Meanwhile, the underlying trend rate of growth of China’s economy continues to fall. It is an inescapable hard economic reality that the additional output generated from an additional unit of physical capital, such as machinery, is decreasing in the level of physical capital. Imitation (of ideas) is cheaper than innovation, but eventually one runs out of things to imitate. And, for China, demographics are particularly unfavourable. Lower fertility (the effects of the one-child policy) and ageing means the working age population (those aged 15-64), which peaked in 2014, is now on a precipitous decline. On United Nations numbers, the working age population will fall 0.3% this year and the drop will accelerate to 1% annually in 15 years’ time. At UniCredit we have estimated that the fall in the working-age population will subtract almost one percentage point from per capita GDP growth next year, and its contribution is projected to remain negative through to 2050.

Furthermore, a major source of growth in China over the past couple of decades has been the surplus of rural labour that has migrated to the (higher productivity) urban areas. In 2010, around 50% of the population lived in urban areas. This rose to 58% in 2017 and is now slightly above the average in developing Asia. This financial benefit from surplus rural labour migrating to urban areas is projected to end in the next five years (the so-called Lewis Turning Point).

Asset prices have already moved. The Shanghai composite index is down 21 percent year-to-date (-26 percent in US dollar terms), well into bear market territory. And the Chinese renminbi has depreciated almost 10 percent against the US dollar since mid-April. While the renminbi depreciation helps to support China’s exports in the face of US tariffs, the authorities will be wary that further significant depreciation will risk domestic capital flight as well as further trade impediments by the US.

The authorities now face a stark choice: resume deleveraging the economy and see the economy inevitably slow, or offset domestic and external weakness by stoking a bigger credit bubble. The one-party state’s main source of legitimacy has been its ability to generate rapid economic growth. That is about to face its biggest test one way or another.

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