With emerging Asian economies now accounting for nearly two-thirds of global growth, China bears have a ready audience for their gloomy prognostications. Some, like the high-profile U.S. economist Tyler Cowen, have been predicting imminent financial collapse for some years. Others, such as the International Monetary Fund, the Organization for Economic Cooperation and Development, and the Bank for International Settlements, have registered rising concern as China's debt has grown consistently faster than its gross domestic product -- a classic forewarning of financial crisis.
Everyone, not least the Chinese authorities, understands that this rising debt ratio cannot continue and that the longer it goes on, the greater the risk of a serious crisis. But just how is it likely to work out?
China's debt-to-GDP ratio is not all that extraordinary by simple global comparison: It is about the same as in many OECD countries. The danger comes from the rate of growth and the fact that the country's debt level is much higher than other countries at China's stage of development. As countries grow, their financial sectors deepen and higher debt ratios are normal. But China, only halfway through the development process, has the debt levels of a mature economy and the ratio is still rising. The level of corporate debt, especially, is way above normal.
That said, comparisons with earlier financial crises do not take us far in understanding how this tension is likely to evolve. A recent IMF study makes comparisons with financial crises in Japan (1990), Thailand (1997) and Spain (2010), but these were quite different from China's current situation.
Take Thailand, which was devastated by the Asian crisis. Many things went wrong, but the driving macroeconomic factor was excessive capital inflow in the years leading up to 1997 (capital inflows equaled 13% of GDP in 1996). This overwhelming funding torrent inflated asset prices, pushed up the exchange rate to uncompetitive levels and opened up a large current account deficit. When the foreign investors realized what was happening, they left in a rush, triggering a plummeting exchange rate, collapse of asset prices and bankruptcy of the financial institutions which depended on the capital inflows.
China's macroeconomic challenge is quite different. It has no dependence at all on foreign savers to fund its investment. It runs a current account surplus, with modest net capital outflow during most of the past three years. Foreign exchange reserves have declined but are still around $3 trillion. China retains capital controls, which would limit any sudden exodus. Thus capital reversal is not the concern.
Nor does China have much in common with America's financial crisis in 2008. The hair-trigger liquidity funding that doomed Lehman Brothers or the complex layers of securitization that brought AIG down are not present in China's simpler financial sector.
China's problems are more like the financial deregulation experiences in the advanced economies a couple of decades ago -- the U.S. with its Savings and Loans crisis in the 1980s and Australia with its overconfident banks in 1990. The intrinsic nature of deregulation results in credit -- and the financial sector -- outpacing the growth of the economy, with financial institutions misusing their newly deregulated freedom to get themselves into trouble.
In this heady transition of financial deepening, some poorly managed financial institutions emerge and some bad lending decisions are made. This has been the universal experience, and has inexorably led to some kind of financial crisis.
Thus the issue for China is not whether it will repeat the Thai experience of 1997 or the Spanish experience of 2010. The solution to China's financial-sector problems does not depend on the fickle favors of the global financial sector. Instead, China has to address some domestic problems -- the nonperforming loans and the flawed financial institutions that made them.
In facing this task, China has a big advantage. This challenge does not come as a total surprise, unlike the Thai and Asian financial crises in 1997, the Savings and Loans crisis of the late 1980s, and the 2008 global financial crisis. Policymakers have time and opportunity to ameliorate the crisis. So what should the Chinese authorities do?
Losses from bad loans
First, there is the micro-level problem of resolving the accumulated bad debts. The IMF estimates that potential losses from bad loans may amount to around 7% of GDP. This would be painful to absorb but could be spread over several years. It would be a fraught political issue to allocate the pain between those who funded the loans (who may see themselves as bank depositors rather than 'at-risk' investors), the financial institutions that made the bad lending decisions, the borrowers who cannot repay, and the taxpayers via the budget. But this is no more difficult than the adjustments that China has made over the past couple of decades.
The key challenge is to ensure that the financial sector emerges from this process stronger and better able to perform its intermediation function. China's saving remains huge (well over 40% of GDP) and financial deepening offers the promise of shifting these funds more efficiently into the most profitable investment opportunities. In an underdeveloped financial sector, investment is largely self-funded. For example, state-owned enterprises put their retained earnings into the management's pet projects, rather than channeling these funds to the higher-return projects in the wider economy.
China should recall the words often attributed to Winston Churchill: "Never let a good crisis go to waste." They should use the impending painful adjustment to achieve a more efficient financial sector. Without wanting to sound too starry-eyed, just imagine if the authorities used the opportunity to drastically restructure zombie state-owned enterprises that have too much debt. History would record this not as a damaging crisis, but as a policy-making triumph.
The second challenge is at the economy-wide macro level: to maintain the pace of GDP growth while trimming back the rate of credit expansion. Derek Sissors of the American Enterprise Institute predicts "years of stagnation," echoing earlier gloomy predictions of Professor Michael Pettis, long-time commentator on China's economy. But it is not as if credit growth has to be drastically curtailed. It needs to be trimmed back so that it rises no faster than the pace of nominal GDP growth, thus keeping the debt-to-GDP ratio from rising further. If China succeeds in its structural switch to consumption-driven growth, this would reduce the need for credit expansion. If, as well, the financial sector does a better job of intermediating saving and investment, this would allow growth to continue with less credit expansion.
All this will be tricky to implement, but it is worth recalling that China achieved its pre-2007 double-digit pace of growth in a period when credit was growing only modestly.
China escaped damage in the 2008 global financial crisis because the authorities applied a huge stimulus (far exceeding 10% of GDP), largely in the form of credit expansion. Now the task is to wean the growth dynamic of the economy off this artificial stimulus. A painful period of adjustment seems inevitable, but a financial crisis is not. China has confounded the pessimists so far and may well do so again.
Stephen Grenville is a non-resident fellow at the Lowy Institute for International Policy in Sydney and a former deputy governor of the Reserve Bank of Australia.