China Update – Why Is the Consensus Now So Optimistic?

As long as China has debt capacity, it can achieve any GDP growth rate Beijing requires, simply by allowing credit to expand. But debt levels are already high, and credit must expand at an accelerating pace to maintain growth. China is probably still a few years away from reaching its debt limits, but the more debt grows, the lower the country’s growth rate average will be over the long term.
Anyone reading news reports about the Chinese economy a year ago might have thought the country was on the verge of financial collapse. There seemed at the time plenty of evidence supporting those who expected an economic breakdown: debt was surging at unprecedented rates, regulators were in disarray following a stock market collapse the previous summer, and liquidity panics periodically swept through the banking system. In addition, so much capital was fleeing the country that even a huge current account surplus couldn’t prevent central bank reserves from eventually declining by nearly a quarter from their June 2014 peak.
But, as I have been arguing for years, China was not on the verge of a financial collapse and was never likely to collapse as long as regulators were credible and able to restructure liabilities in the banking system with relative ease. Financial crises are caused not by insolvency or economic downturns, but rather by highly inverted asset-liability mismatches severe enough to cause a breakdown when evaporating liquidity prevents the rolling over of liabilities. On paper, the Chinese financial system seems plagued by such mismatches, but liabilities in a closed banking system with all-powerful regulators are much more stable than they seem because the regulators have many ways to restructure liabilities through the banking system.

This post was published at FinancialSense on 04/19/2017.