Back in 2001, Goldman Sachs’ Jim O’Neill coined the term BRICs to describe the key fast growing developing economies of Brazil, Russia, India and China. But a dozen years later, is the focus on the BRICs misplaced? Indeed, is the group “broken,” as Morgan Stanley’s Ruchir Sharma has suggested?
“Although the world can expect more breakout nations to emerge from the bottom income tier, at the top and the middle, the new global economic order will probably look more like the old one than most observers predict,” Sharma wrote earlier this year. “The rest may continue to rise, but they will rise more slowly and unevenly than many experts are anticipating. And precious few will ever reach the income levels of the developed world.”
Each day this week, a leading analyst will assess the prospects of a BRIC nation and weigh in on whether it still deserves its place in a group of economic high flyers. Today, Minxin Pei looks at China, the only country that Sharma was relatively upbeat about.
By Minxin Pei, Special to CNN
Editor’s note: Minxin Pei is the Tom and Margot Pritzker ’72 Professor of Government at Claremont McKenna College and a non-resident senior fellow of the German Marshall Fund of the United States. The views expressed are his own.
Recent economic turmoil in major emerging market economies such as India, Indonesia, Turkey, Brazil, and South Africa has apparently made China, for all its economic woes, an oasis of stability. Its currency, the renminbi, remains stable; its economic growth, though slowing down, is expected to reach 7 percent this year, the fastest among major economies.
But appearances are deceiving. Behind these statistics lies a far more fragile Chinese economic reality. The relative calm of the Chinese economy actually conceals far greater risks.
The biggest short-term risk is financial overleveraging. Thanks to its decade-long credit boom, the Chinese economy as a whole is far more leveraged (indebted) than any of the major emerging market economies. Net domestic credit as a share of GDP is close to 140 percent in China, compared with roughly 90 for Brazil, 75 for India, 60 for Turkey, and 35 for Indonesia. To make matters worse, most of the debt is owed by state-owned companies, real estate developers, and local governments that are known for wasting capital on financially unprofitable investments.
For now, the bad debts incurred by these borrowers are not recognized on the balance sheet of Chinese banks, which are ordered by the Chinese government to roll over these loans. Estimates of bad loans hidden in Chinese banks vary, due to the opacity of the Chinese financial system. The most conservative estimates suggest they are around 10 percent to 15 percent of GDP. If that is true, the Chinese banking system is technically insolvent.
Thanks to its capital control and state ownership of banks, China does not face an imminent financial meltdown (since the government can maintain liquidity), but Chinese banks will have to be recapitalized at some point – an expensive, time-consuming and technically complex process that will have a substantial negative impact on future growth.
Even if Beijing manages, through a combination of inflation and clever accounting gimmicks (such as shifting bad loans to off-balance sheet financial entities), to make its banks healthy again, it has to confront a tough medium-term challenge: cutting China’s massive excess capacity in most industries. Much of China’s investment, the most critical factor of its sustained rapid growth, has gone into manufacturing and infrastructure. As a result, excess capacity is plaguing major manufacturing industries (such as steel, cement, automobile, solar panel, wind turbines, and many others) and destroying profitability in sector after sector. To restore profitability and kill zombie firms that are now kept alive only by bank loans, China will have to shut down many companies – a politically difficult task. More importantly, Beijing will have to follow up this painful restructuring with far-reaching financial sector reform so that investments in the future will not flow into sectors with excess capacity.
Whether China can deal with these two challenges is anybody’s guess. However, one thing is clear – mountainous bad loans hiding in the balance sheet of Chinese banks and massive overcapacity in its manufacturing industries are not going away. Even a successful resolution of these problems will unavoidably entail years of slower growth. Compared with other emerging economies, China’s problems are far bigger and more complex. They may appear manageable at the moment, but in the next one to two years, when the full magnitude of China’s macroeconomic risks and structural deficiencies are fully exposed, Beijing will likely face its most lethal economic crisis since the end of the Mao era.