What are the source of China’s problems?
1. An over-reliance on investment in things like transport infrastructure and housing to drive growth.
2. A rapid build-up in debt to feed the investment boom.
Over the past 30 years many countries have accumulated debt at a similar pace to China, including Japan, Sweden, Indonesia, Thailand, Ireland, the US and even the UK. The worrying precedent is that each of those countries subsequently suffered a financial crisis. China’s problem is that its investment is not generating sufficient returns to repay the debt. The scale of China’s challenge is potentially very large.
In every single minute since the financial crisis, gross debt in China has risen by £2.7 million.
Where will the pain be felt?
As is almost always the case with rapid debt build-ups, it’s the banking sector that will feel the pain. We think China’s banking sector is sitting on problem loans far in excess of the official figures. We estimate the problem could easily be big enough to wipe out the banking sector’s capital and reserves.
What does it mean for China’s growth?
Despite having the ingredients for a financial crisis we think China can avoid such a fallout. And China has the cash to return its banking sector to health. But it won’t be plain-sailing. China is heavily reliant on its banking system so any problems there will be reverberate around its economy.
At the same time the government is beginning to undertake deep-rooted structural reform to make the economy less reliant on investment-led growth. That’s good news in the medium-to-long-term. But coupled with banking sector stress it’s a recipe for lower growth in the near-term. China’s growth has been on a downward trajectory for five years, but it likely has further to run.
What are the consequences for the UK?
The UK is far from immune to China’s slowdown. The consequences come in various forms, some of which are already happening.
- Economic growth – Global economic growth is already slow, partly due to a weak Eurozone. It’s now being compounded by China. If China’s growth slows to 4% from its current 7%, the loss to global output will be greater than the Eurozone slowdown of 2012 which contributed to the stalling of the UK’s post-crisis recovery.
- UK trade – UK exports to China are only a third of what we send to the US, but this has more than trebled since 2007. In other words, China has been an export success story for the UK while global trade has struggled in the face of weak global demand.
- UK financial sector – The UK’s financial exposure to China has risen by a staggering 300% since the financial crisis and is now not far behind the UK’s exposure to France. It’s similar to the UK’s exposure to Ireland on the eve of its financial crisis in 2007/08.
- Oil and commodities – Here there is a bit more good news, for UK household finances anyway. Although increased supply oil from the US explains a lot of the recent fall in oil prices, weaker demand from China is also a reason.
- Interest rates – China’s role in the global economy is significant enough to influence the decisions taken by the Bank of England in setting rates. As recently as July, expectations were that UK rates would begin rising in March of this year. That date has moved to the middle of 2016.
The changes taking place in China’s economy will matter hugely to the UK and other economies over the course of 2015 and beyond.
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