China’s policymakers are aggressively clamping down on what some experts are calling a credit bubble. This comes as China’s economy slows and incoming data continues to disappoint.

All of this has economists upping their odds of a hard economic landing, a scenario where growth slows to a point that causes unemployment to spike.

China’s economic problems are well documented

China Economist Wei Yao of Societe Generale SA (OTCMKTS:SCGLY) (EPA:GLE) noted while the problems facing the Chinese economy are well documented, they think many investors may still be relatively complacent about the risk of a hard landing. This could prove a costly mistake. The Chinese economy is still imbalanced: almost 50% of GDP comes from gross fixed capital formation, up from a third in 1997. Massive excess capacity, high and rising corporate debt and an increasingly marginalized private sector are other symptoms of deeply rooted imbalances in China’s economy.


Chinese economy is set on a path of structural deceleration

Societe Generale SA (OTCMKTS:SCGLY) (EPA:GLE) think the Chinese economy is set on a path of structural deceleration, due to deeply rooted imbalances. Symptoms include a massive amount of excess capacity, high and rising corporate and local government debt, as well as an increasingly marginalised private sector. All of these contribute to the concerning trend of deteriorating productivity growth. In their view, there is no other ending to China’s massive resource and credit misallocation than a painful bursting of the bubble. The question is rather when it will start unwinding and at what pace.

China faces a bumpy path of persistent deceleration

Societe Generale SA (OTCMKTS:SCGLY) (EPA:GLE)’s central scenario is a bumpy path of persistent deceleration over the next five years, with 2017 growth touching 6%. The assumption is that the new leadership will somehow succeed in gradually deflating the existing bubbles through carefully sequenced reforms. However, this piece focuses on the other possibility – not a small one – that this slow bursting process may get out of control at some point and morph into a much sharper correction. In other words – a hard landing.

They define a hard landing in 2013 as one where the official, full-year real GDP growth rate plummets to below 6%, which they see as the minimum level needed to keep the job market stable and avoid systemic financial risk. As China’s population ages and growth of the working-age population also slows, the minimum level for stable growth will decline further. If progress in rebalancing and structural reform remains slow however, then a hard landing will become inevitable in the medium term.

In the tail-risk scenario, China’s economic growth will drop sharply to an average of just 3% in H2 2013 and H1 2014, compared with their central scenario of 7.1%.

China: What are the most likely triggers?

Societe Generale SA (OTCMKTS:SCGLY) (EPA:GLE) noted that two types of events could trigger a hard landing in China.

First, the experience of 2008 showed that the Chinese economy is vulnerable to trade shocks. The Lehman crisis made exports go into reverse, resulting in the loss of nearly 50 million migrant worker jobs in the two quarters after it took place.

Second, a hard landing could be provoked by either insufficient public investment from Beijing or an intended credit deleveraging going out of control. Policymakers might choose to do so out of concerns over systemic risks posed by the uncomfortably rapid credit growth.

The point is that they would not deliberately choose to force a quick correction, but as China’s imbalances are already at a precarious level, the room for error and the likelihood of nasty unintended consequences is not negligible. However, China is unlikely to experience a currency crisis like the Asian Financial Crisis, as it has little external debt and a still largely controlled capital account.

China’s evolving crisis

Whatever the catalyst, the excess capacity in the manufacturing sector – estimated at 40% in 2011 by the IMF – would be exacerbated by a sharp growth slowdown. This would cut corporate margins sharply, making profits plunge, and triggering a downward spiral in domestic demand. Bankruptcies and unemployment would occur on a large scale, endangering financial and social stability. One factor that could accelerate the downward spiral is the high leverage of China’s corporate sector and local governments, which we estimate has reached 145-150% of GDP at end-2012.



China’s choice of responses

Societe Generale SA (OTCMKTS:SCGLY) (EPA:GLE) said an easier but more dangerous choice would be for Beijing to repeat the post-Lehman package of massive state-driven lending and investment facilitated by ultra-low interest rates and ample liquidity. However, such a solution would be less effective than in 2009 given the overhang in capacity, and would increase corporate leverage even further. A more judicious response would combine genuine tax cuts to lower the burden on the corporate sector, further liberalization to give private enterprises new space to grow, more social spending to anchor consumption, and selective state investment to prepare China better for future challenges.

Here is one crisis scenario, where GDP drops to 3% and the government fails to stimulate the economy.