May 16, 2017 / 12:01 PM / 3 months ago

COLUMN-China creaks under much-needed credit crackdown -James Saft

(The opinions expressed here are those of the author, a columnist for Reuters.)

By James Saft

May 16 (Reuters) - The good news is China is taking a safer route in its approach to financial regulation.

That, unfortunately, is also the bad news, as a crackdown on loose lending, especially after a splurge of credit into unproductive sectors, means China's growth is and will be declining.

That’s significant not only because China is the world’s buyer of last resort of raw materials, but also because the slowing of any credit binge brings with it the possibility, even in tightly controlled China, of missteps and blow-ups.

China’s factory output slowed to 6.5 percent in April, year-on-year, falling from 7.6 percent in March. Investment in fixed assets over the first four months of the year rose 8.9 percent, down three-tenths of a percent from its recent rate of expansion.

Fixed asset investment in manufacturing grew at a less than 5 percent annual rate, but the overall figure was buoyed by continued state-backed spending on infrastructure, still expanding at a clip over 20 percent.

Underlying the slowdown is a new get-tough approach to banking and shadow-banking speculative credit. Authorities intensified efforts in April to rein in off-balance-sheet financing, causing total social financing, the broadest measure of credit, to fall by 30 percent in a month.

"The key development to watch is the financial regulatory tightening. There are clear signs of this line of action already biting the shadow-banking system," Wei Yao and Claire Huan of Societe Generale write in a note to clients.

"In any case, the overall credit growth slowdown is not boding well for economic growth down the road."

So-called "entrusted loans," those between corporations but usually administered by a bank, have been a major source of liquidity but fell by half in April compared with March.

As part of a campaign to emphasize financial sector stability, widely viewed as a measure to ensure a smooth landing for President Xi Jinping before he reshuffles top officials at a party congress in the third quarter, banks and other intermediaries have been under sudden and intense pressure to show relative prudence.

Taking the long view, this is very good news. Total debt in China is now upward of 250 percent of annual economic output. That's lower than the 330 percent or so in the United States, but expansion has been rapid and much of it concentrated in unproductive industries and often empty investment property.

CROWDING OUT, GROWING SLOWLY

China finds itself in this situation in large part because, although authorities have firmer controls over the economic levers than U.S. or European officials, these levers move gears in an economy that is still hugely dependent on investment and export rather than consumption.

While authorities have wanted for years to develop domestic consumption, efforts to make this happen have largely been both debt-fueled and ended in investment - in property, for example - and in less-efficient state-owned enterprises, or SOEs.

By some estimates China now uses four dollars of debt to create every dollar of economic output, as compared with recent averages in the United States of about 2.5 times. That figure indicates both why further debt expansion can be dangerous and is also a clue to the quality of the investments made thus far.

Efforts in 2016 to increase growth saw credit flowing increasingly to inefficient and debt-laden SOEs. While investment by the state sector had nearly halved as a percent of the whole in the decade to 2015, it has since grown again and once again surpassed private investment. But even that in the past year has shown diminishing returns in economic growth.

Loans to firms at below bank benchmark rates, usually loans to state-owned companies, accelerated to about 30 percent of the total. But these firms slowed investment, a potential sign of financial distress.

"Corporate debt in China is approaching a dangerous level by both historical and cross-country standards, which clearly represents the No. 1 risk to the global macroeconomic outlook," Edoardo Campanella of UniCredit wrote in a client note.

"The recipe adopted by Beijing so far is not self-sustaining and likely self-defeating. It opted for the old actor (the SOEs), the old economy (heavy industries) and the old instrument (demand-management policies through higher credit) to grow out of debt."

What may well be happening is that the crackdown on credit is disproportionately hitting privately owned firms, which are less well-connected and employ fewer but are more efficient. In other words, the crowding out of private enterprise by state firms has lowered China's growth potential.

A safer, more stable China is good for the rest of the world, but getting there may not be pleasant.

At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft Editing by Dan Grebler

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