Credit complacency

Noises emanating from the People’s Bank of China suggest that those responsible for ensuring China’s financial stability are worried about the consequences of this year’s lending glut. So they should be.

In the first half of the year, China’s banks pumped nearly US$1.1 trillion of new loans into the economy, compared with US$717 billion for all of 2008. Wu Xiaoling, who stepped down as the deputy governor of China’s central bank last year, has warned that lending could reach US$2 trillion if the taps are not turned off.

Although new loans fell sharply in July, there are no signs of a change in direction from the top. Premier Wen Jiabao and other senior policy makers insist that the country’s ultra-loose (they call it "moderately relaxed") monetary policy remains unchanged. They fear it is too early to declare that China is out of the woods. There is also the small matter of the PRC’s 60th birthday party to worry about on October 1: nothing must be allowed to spoil the glorious celebration.

But elsewhere there are dangerous signs of complacency. The People’s Daily – officialdom’s official rag – last month ran a smug editorial praising "China’s spirit" for leading the country back from the global economic abyss after it recorded 7.9% growth in the second quarter of this year. "This situation in China is in sharp contrast with Western developed nations, where the economic growth has kept sliding," the editorial opined, heralding China’s "great foresight" and "heroism to forge ahead in the face of difficulty and hardship."

Unfortunately, there is nothing remarkable or spiritual about an economy growing at 8% when credit is allowed to expand by 34%. It looks even less remarkable when you consider that nominal GDP (the appropriate comparator for nominal credit growth) grew less than 4% in the first half. Put another way, US$10 of new loans were required to generate just US$1 of economic growth. The turnaround of the past few months is both unsustainable and wasteful.

The good people at the central bank know this. They fear that a tsunami of loans will inevitably become a disaster of bad debt. Although headline inflation remains negative, the flood of liquidity sloshing around the economy is already pouring into the stock and property markets, and pumping up prices wherever it goes.

With the Shanghai stock market up more than 50% this year and average price-to-equity ratios riding high, the market looks overheated. But swelling reserves of cash coupled with the merry-go-round mentality of private investors mean that prices will likely go much higher.

After months in the doldrums, the property market is set to surge: housing inventories in major cities have dropped sharply, and available investment funds are up more than 20% on last year. Property developers are jumping back into the market, with credit-financed investments close to the levels seen during the boom in 2007.

Back then, when policy makers realized the property market was out of control, they slammed on the brakes and the bubble burst spectacularly. And yet the seeds of another glut are being sown. Of course, the situation today is nothing like 2007. But doling out loans like sweeties is not the smartest way to run an economy. People will get sick.