If you’ve ever wondered why I keep harping on China’s failure to live up to the terms of its joining the World Trade Organization and loosing its hold on its banking system, Michael Pettis’s remarks at Bloomberg View might give you a hint:
In China, the government sets the GDP growth rate early in the year at a level thought adequate to accommodate its social and political objectives, among which is to keep unemployment low. The political nature of the target modifies the standard economic constraints, encouraging local governments to generate whatever additional economic activity is required so that, along with the economic activity of the private and real-estate sectors, the target is reached (within a few tenths of a percentage point).
Two factors unique to China are critical for this system to work. First, till now local governments haven’t been subject to hard budget constraints. They can engage in near-unlimited amounts of non-productive economic activity unconstrained by worries about remaining solvent.
Second, and necessary for the first, local governments control most credit creation within the banking system. Because such loans are directly or indirectly guaranteed, banks don’t have to write down loans when the projects they fund cannot service the debt. This allows the banks to extend as much new credit as local governments need to meet their targets.
China’s debt-to-GDP ratio is pushing 300%. Much of this debt is non-productive and some considerable amount is just plain corruption. It has maintained a high GDP growth rate through increasing its debt rapidly. Can it maintain that indefinitely? No one knows. If it doesn’t, it won’t be good for any of us.
