CHINA RISKS CREDIT-FUELLED MINSKY MOMENT / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

China risks credit-fuelled Minsky moment


By George Magnus

Published: May 3 2011 23:16

China is widely seen as a beacon of sustained economic expansion and financial stability, in contrast to a troubled western world. However it is worth asking whether China’s investment-intensive growth model, and developments in credit and inflation, are pushing it towards its own version of a “Minsky moment” – named after the US economist who warned that the process of leverage always culminates in instability. As western countries discovered in 2008, this is the point at which policy or other endogenous shocks lead to financial instability and falls in asset prices, investment and economic growth. Could China be flirting with a similar outcome?


China’s transition over the past decade from low to borderline-middle per capita income has been based on an investment-intensive growth model. This has seen the investment share of gross domestic product rise from about 35 per cent in the late 1980s to an unprecedented 47 per cent today. More than half this rise was related to property investment.


Yet investment’s share of GDP cannot keep rising, since chronic overcapacity would eventually cause investment returns to collapse. Although corporate profits have been robust, they are boosted by subsidies to energy prices, for example, and by a monetary system that diverts income away from households and underprices capital. A sharp rise since 2000 in the ratio of capital to output does not make China unique among emerging markets, but it is worrying when the investment share of GDP is so high and the quality of investment financing is deteriorating.


But a more immediate worry is the growing credit intensity of China’s economy. What China calls “total social financing” – conventional bank loans and most other external sources of finance – was still 38 per cent of GDP in the first quarter of 2011, almost as high as in 2009 when China implemented a credit-centric stimulus programme. The credit intensity of growth, or the amount of new credit generated for each unit of GDP growth, has risen from 1-1.3 before 2009 to 4.3 in 2011.


Despite a 500 basis points rise in bank reserve requirement ratios since January 2010, and four 25bp increases in interest rates since October, credit demand and supply seem barely affected. In real terms, interest rate levels are the lowest for 13 years: the three-month deposit rate stands at -3 per cent, and the one-year lending rate at 1 per cent. Companies are borrowing more as cash-flows weaken, with energy, utility and wage bills rising.
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Although formal bank loan volumes are subject to restraint, they only comprise about half of TSF. Companies can also access plentiful liquidity in Hong Kong, where the renminbi deposit market has increased eightfold since mid-2010 to more than RMB400bn and where offshore renminbi financing is rising fast.


Minsky stressed the vulnerability of banking systems, but the integrity of China’s state banking system is not the key issue. Foreign exchange reserves of $3,000bn give ample ammunition for recapitalisation and the China Regulatory Banking Commission, which warns regularly about the risk of excessive lending and borrowing, has already set a minimum 11.5 per cent capital ratio.
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But financial instability, arising from excessive credit, increasing inflation and weak investment returns, is always an important catalyst. That is why China’s current inflation rate of almost 5.5 per cent, and its policy response, should be monitored closely. Decisive, sustained measures to put China’s inflation and credit genies back in the bottle, including a significant rise in interest rates, would hit cyclical growth. But they would make growth more sustainable by taming investment and allowing time for other measures to boost household incomes and consumption.
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A different scenario is all too plausible. In this, the leadership changeover in 2012, a reluctance to compromise growth or alienate workers, and political interests in rising property prices could lead to a premature call of victory over inflation. This might boost asset price and growth in the short term, but increase the likelihood the new leadership will have to deal with a credit-fuelled Minsky moment.
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A Chinese Minsky moment would hit global growth and resource markets, and shock the consensus about steady appreciation of the renminbi. It would also undermine China’s aim of rebalancing its economy towards consumers; and raise the risk of political unrest.
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The writer is author of Uprising: will emerging markets shape or shake the world economy, and senior economic adviser at UBS
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Copyright The Financial Times Limited 2011