China is seen as a major risk for the global economy. The country has a very high credit-to-gross domestic product ratio by international and its own historical standards, and it has mounds of bad loans.
But is China's economy headed for a train wreck? Not quite.
A rising tide of bad debt is sometimes the result of some policy distortion, such as controlled interest rates or fixed exchange rates, as was the case in Thailand in 1997. More often than not, piles of bad debt are just the result of a slowing economy. The high bad debt we see today in China, southern Europe and Latin America all relate to the throes of normal business cycles, although policy distortions play a big role, too.
If the business cycle is the main reason for mounting bad debt then the sensible solution is to throw good money after bad, no matter how counterintuitive this may appear. The government should encourage the private sector to increase lending or take matters into its own hands. In the cases of Thailand, Indonesia and South Korea nearly 20 years ago, it was more credit, not less, that eventually lifted those economies out of crisis.
The loan conditions imposed by the International Monetary Fund and the World Bank, typically including demands for tightening of fiscal discipline and allowing companies to collapse, are unpopular among crisis-hit countries for good reason. While they may make sense from the creditors' point of view, they can be counterproductive for borrowers.
This logic extends to austerity as a policy response to crises in general. When a policy distortion needs to be smoothed out, an easier credit environment will only help. By the same token, to resuscitate a sagging economy, a loose credit environment is better than a tight one, although recent experiences in Japan and Europe suggest that lax credit alone is sometimes not enough.
In and of itself, a high credit-to-GDP ratio does not cause a crisis, and does not even herald a crisis. No one can pinpoint a threshold above which a crisis will erupt, and why.
The emergence of a credit crisis such as the 1997-98 one in Asia or the 2008 one in the U.S. usually does not stop the credit-to-GDP ratio from continuing to rise. On the contrary, the ratio often will go up even faster.
International comparisons suggest that there is no correlation between a high credit ratio and a credit crisis. For example, Japan and Taiwan have had very high ratios for over two decades but have not suffered a credit crisis.
No imminent crisis
China's high credit-to-GDP ratio reflects poor returns on investments and the destruction of surplus savings. China is a slow-burn country, not a country with a looming credit crisis.
China is not Japan of the early 1990s. In the 15 years after Japan's asset bubble burst in 1990, the economy went through a balance sheet recession. While every Japanese citizen may have been rational in trimming his debt and trying to save more, the consequence for the economy and everyone's income was disastrous.
Unlike Japan in that period, loan volumes are still growing 13% in China. Over time, China's mounds of bad debt will be swept away in the next economic recovery. Sure, many banks are currently operating with a very thin cushion of capital, but what is a cushion for, if not the absorption of loan losses?
Forcing banks to write off bad loans and recapitalize would be a grave mistake. China has made that mistake before. In 1999, after finding that many banks were technically insolvent due to soured loans, China proceeded with a major recapitalization effort, even though liquidity was adequate, public confidence solid and loan growth strong. The result of that ill-advised recapitalization was excessively high credit growth to this day.
This logic also applies to fiscal deficits. The insistence that a government must keep a certain level of fiscal reserves at all times is to forget the very purpose of such reserves. In hard times, they much be allowed to be drawn down. Similarly, in hard times banks must be allowed to get by with a lower capital cushion; some officials are signaling that the China Banking Regulatory Commission may wisely lower the fraction of funds that must be set aside against soured debt.
China today is just going through a process of bank capital depletion. Like in 1999, the banks today enjoy high liquidity, high public confidence and high loan growth. Over time, they will grow out of this trough and build a capital cushion again. To panic and recapitalize would be to repeat the mistakes of 1999.
Joe Zhang is chairman of payment services company China Smartpay Group and a director of China Rapid Finance, Fosun International, Wanda Hotel Development and Guangzhou Huadu Wansui Micro Credit. He is the author of "Party Man, Company Man: Is China's State Capitalism Doomed?"