Chinese Test: Smog and Debts

26.03.14 Publication:

One eternal truth about modern China is that it is constantly changing. No sooner than you think you understand what is going on, especially in the economy, than you find you are out of date. That is inevitable in an economy whose size has been doubling every 7-10 years, and which is now more than 25 times bigger and richer than when the then leader, Deng Xiaoping, began the shift from Maoist central planning to market-based capitalism in 1978. But one thing stays the same: politics matters much more than economics.

Visiting Beijing last week two phenomena caught my eye. One was that despite some beautifully sunny days free of smog, everyone I met seemed constantly to be studying their smart-phones, using apps to tell them the latest ratings for air pollution in the capital city.

The air seemed surprisingly clear to this visitor, but all my friends shook their heads, saying how rare the blue skies were but also how their phones were telling them that even on these lovely days the level of dangerous, carcinogenic particles in the air was many times higher than the level the World Health Organisation considers to be safe.

The second of the two phenomena was that the news was suddenly spattered with stories of companies defaulting on their debts—even being pushed to do so by the government or by state-owned banks.

Since the global financial crisis began in 2008, Chinese economic growth has been driven largely by big expansions of credit, both to the private sector and to local governments. That credit expansion is now being slowed down, and the word has gone out from central government that insolvent companies will not necessarily be rescued. They will be allowed to go bankrupt, in order to reintroduce some market discipline.

Dirty air, along with dirty water and contaminated food, has become during the past decade one of the defining features of China’s economic story. So has debt, the growth of which has been associated at least anecdotally with the construction of office buildings and apartment blocks that stand empty, with rapid change in the financial sector and the rise of what in the West was a phrase linked to the 2008 crash, “shadow banking”, in other words unregulated finance, which also can mean dangerous finance.

As a result, the combination of these steadily worsening environmental problems with the scary growth of debt has led to many predictions, mainly from westerners but also some Chinese, of imminent disaster. Economic growth had anyway been slowing down, from annual inflation-adjusted rates of more than 10% down to the still rapid rate of 7.5%. Might it now be about to collapse, buried by debt and choking on the air?

The answer lies partly in economics but chiefly in politics. The economic part of the answer is that debt has indeed grown rapidly and often wastefully, but from a fairly low starting point. The financial system remains principally controlled by state-owned banks. So if loans do turn bad, the consequence will not be shocks akin to Lehman Brothers but rather rising costs for the Treasury.

The figures are not entirely transparent. But the best estimates are that currently the debt of central and local governments combined amounts to about 55-60% of GDP, which is less than half the public-debt-to-GDP ratio of Italy. A rise in the ratio, caused by loan losses at state-owned banks, would be a move in the wrong direction, potentially storing up trouble for the future. But it can be afforded, at least for the next decade or more, just as Italy was able to afford a rising level of debt during the 1970s and 1980s.

The real issue is the politics of this process of cleaning up reckless lending and dealing with the huge waste of capital that has occurred during the past five years. And that is the real issue with the environment too.

If you look at speeches by the Chinese Communist Party’s top leadership during the past five years, or even a longer period, and look too at their “five-year plans”, you will find promise after promise after promise of a “rebalancing” of the economy, of an end to an “unsustainable” direction, of the cleaning up both of the environment and of bad lending. But little has actually happened, on either.

The leadership of President Hu Jintao and Prime Minister Wen Jiabao were either too weak or too unwilling to carry out their promises. Independent studies have concluded that there could now be more than one million premature deaths each year thanks to air pollution. In a population of 1.3 billion, it may not sound much. But it means that air pollution has already become the fourth most common cause of death among adults, even though many of the results of absorbing carcinogenic particles into the lungs will not be seen for many years to come.

Now, there is a new leadership, and it is talking and acting a lot tougher. President Xi Jinping and his premier, Le Keqiang, have taken a tight grip since they arrived in office last year. In China, there always seems to be some sort of anti-corruption drive, but President Xi’s such drive has been broader and more ruthless than any for two decades, leading to the sacking and arrest of thousands of top officials in the party and in powerful state-owned enterprises, and so to the removal of many potential enemies.

It is a purge of which the old communist dictators might be proud. But it is being combined with increased talk of using un-communist sources of discipline too, namely the market and private enterprise. Hence the spate of debt defaults, as the leadership has declared that it will not rescue bankrupt firms. And now, some new optimism about the environment. After all, even the party leadership have to breathe the air. And they have to worry about public protest, the most common focus of which has become the environment.

Will the new leadership make a difference? We can’t know. But we can know that the main test of their strength and determination is going to be their confrontation with the many interest groups—often in local governments and state-owned enterprises—that profit from pollution, and that have grown dependent on a continued flow of easy credit.

Two sorts of places are filling up, fast: the prisons and labour camps, with purged senior officials; and now the bankruptcy lists. The more that it happens, the more optimistic outside investors and observers should become about China. Only if it halts, either because of political timidity or mass popular disturbances, should you worry. China has the potential to make a lot more economic progress. Whether it does so or not is in the hands of politics.