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Wasteful infrastructure investment driven by an unregulated credit bubble remains the primary risk to Chinese economic growth. Credit Suisse economist Dong Tao describes the current path of credit expansion as the "Road to heightened risk," and his conclusions have important ramifications for Canadian investors.
The unregulated shadow banking sector now accounts for 22.8-trillion yuan ($3.74-trillion), or 25 per cent of all outstanding Chinese credit, despite barely existing before 2007. Mr. Tao writes that "the fund raising and lending activities of the shadow banks are fraught with irregularities. Many products currently offered look like the CDOs offered in the U.S. before the financial crisis." The stunning lack of transparency and financial viability of many of the products offered by the shadow banks were also detailed in a highly disturbing Reuters report from 2012.
Credit Suisse does believe that with a public debt to GDP ratio of 15 per cent, the Chinese government can engineer a bailout of major credit institutions when the non-performing loan situation becomes acute. However, Mr. Tao believes that even a small number of defaults would trigger a bailout of the wider financial system and result in a contraction of overall credit growth.
Shadow banking operations are currently used primarily to fund government infrastructure projects. A slowdown in credit creation would have large effects on national GDP growth because "private investment has disappeared in China, as manufacturing production becomes unprofitable due to surging salaries and severe overcapacity."
With the private sector reeling and retail spending soft so far in 2013, China's economy is dependent on infrastructure investment for growth. Slower credit growth would threaten infrastructure spending and – important for Canadian investors – the country's demand for commodities.
China's current economic growth path appears less sustainable by the day. Hopes for the expansion of its economy are now narrowly focused on infrastructure spending which, in turn, is dependent on financing from sales of increasingly sketchy products sold by the shadow banking system.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.
Scott Barlow