“Policymakers will soon have to decide how much short-term slowdown they are willing to tolerate in exchange for a more efficient economic system, in which 100% implicit state guarantees are shattered and so creative destruction becomes possible,” says a recent Economics research note on China from SocGen.

China

China GDP growth stifled by slow credit growth

SocGen forecasts that Chinese GDP would grow by only 6.9% during 2014, mainly due to a marked slowdown in credit growth in evidence since June 2013.

That month, the People’s Bank of China (PBOC) embarked upon a drive to curb flows of credit into China’s notorious shadow banking channels by raising interbank lending rates. The strategy had mixed results, causing huge spikes in interest rates that threw markets into turmoil, and indirectly sparking near-defaults such as the ‘Credit Equals Gold’ product that had to be bailed out by the authorities at the last minute.

But the ramifications on credit growth were unmistakable – SocGen estimates that total credit growth decelerated from 22% year-on-year in June to sub-18% levels by the end of 2013.

China: Regulatory crackdown to add to the pressure

SocGen also note that shadow banking is likely heading for considerable regulatory heat in the near future, as indicated by the issue last month of Document 107 by the State Council, the top decision-making body of the Chinese government.

This document lays out a regulatory structure for dealing with shadow banking, and gives more teeth to an interagency group called the Financial Stability Coordinating Committee, says a recent article in the WSJ, which highlights the cracks showing up between the PBOC and the China Banking Regulatory Commission (CBRC) regarding reining in the credit bubble and the shadow financial system.

Global calls for checks and balances

The tightening by the PBOC and its effect on the Chinese financial system, as well as the ‘Credit Equals Gold’ debacle, brought the Chinese credit expansion and shadow system into global center-stage.

“Financial risks continue to rise. The government keeps delaying structural overhauls. Debt keeps getting rolled over. That creates zombie banks and zombie corporations. Eventually it causes GDP to weaken and the financial sector to deteriorate,” said Haibin Zhu, J.P. Morgan’s top Chinese economist, and quoted in the above mentioned WSJ article.

“The banking sector has extended $14 trillion to $15 trillion in the span of five years. There’s no way that we are not going to have massive problems in China,” said banking analyst Charlene Chu in an article in the Telegraph recently and featured on ValueWalk here.

China’s real estate and infrastructure to be most affected

According to SocGen, increasing credit growth is exhibiting diminishing returns in the form of GDP growth, even though credit growth traditionally leads GDP growth, as shown in the chart below.

China credit gdp-growth

“We note that, directionally, total credit growth has steadily led GDP growth since the early 2000s by one to two quarters in real terms and three to four quarters in nominal terms. However, for a same amount of acceleration in credit growth, there has been less and less pick-up in economic growth,” says the report.

In fact, the growth has now been skewed more towards real estate and infrastructure sectors compared to manufacturing.

Both real estate and infrastructure rely heavily on financing from the shadow banking industry, and the credit as well as regulatory tightening could impinge growth in these sectors, says SocGen.

No gain without pain

Another factor that clouds the outlook on Chinese growth is the likelihood of financial defaults – to the extent they are allowed to happen by the authorities.

“Defaults on financial market securities – trust products and/or corporate bonds – would finally happen and lead to a more pronounced credit and economic slowdown,” says the research note. “We see conditions ripe for defaults to occur: slowing credit growth, elevated costs of funding, waning economic momentum and tighter financial regulations.”

According to SocGen, Beijing would face the unenviable trade-off between a systemic purge of the underlying problems and the cost incurred in terms of economic growth.

“For 2014, we do not envisage systemic meltdown, but rather financial disruption. Even in that case, the resulting economic growth deceleration would test the new leaders’ tolerance of short-term pain,” warns SocGen.