On the eve of the most important meeting since the initiation of trade hostilities between the US and China, the Chinese economy is staring down another wave of pressure.
US President Donald Trump and Chinese President Xi Jinping are set to meet during the G20 Meeting in Osaka, Japan, on June 28 to discuss trade issues between the two countries.
And part of the pressure on China’s economy right now does indeed stem from the trade war.
But more of it stems from an old problem — the same structural issue that has plagued China’s economy for years now — an overindebted, underproductive corporate and financial sector.
Chinese policymakers have been trying to inject credit into the system in a targeted way since July, but recent data indicates that those measures will not be enough to stop a slowdown. This problem has become most evident in the financial sector, where the government has been forced to take aggressive action to help struggling banks.
There are few on Wall Street, in Washington, and in Beijing who have high hopes for any kind of progress in negotiations coming from this Osaka meeting. Chinese state media has been defiant, blasting the US for its role in abruptly ending discussions last month and claiming to stand for international order and a rules-based trade regime.
The Wall Street Journal also reported that the Chinese delegation plans to go to the meeting with a list of demands likely to upset Trump, like dropping a ban on the Chinese telecom company Huawei.
Analysts at Capital Economics told clients that the best-case scenario would be for the two sides come to some kind of temporary truce.
That may not be enough to ease the strain on China’s economy right now. And, of course, an escalation of hostilities — say, if Trump decides to put 25% tariffs on an addition $300 billion worth of Chinese goods as he has threatened — could wreak havoc on an economy that appears stable but weak.
You’ll recall that at the end of last year, the Chinese economy was having a concerning meltdown, and policymakers responded by loosening credit conditions. By early spring, it looked like things were stabilizing and growing again, though the analyst Charlene Chu of Autonomous Research told Business Insider that to sustain that, policymakers would have to throw tons of cash at the problem and “post in nominal terms a record flow of credit” the following year.
Come June, it was clear the good times wouldn’t last that long. The May economic data out of China was bad. Here’s a selected rundown:
- Industrial production growth slowed to 5%, a pace unseen since the financial crisis in 2009.
- Electricity production growth fell from 3.8% in April to just 0.2% in May.
- Infrastructure investment growth fell to 3% from 4.8% in April.
- And in value terms, land sales remained in a funk at -39.9% in May, only slightly better than -47.7% in April.
So policymakers sprang into action again. Whereas previous actions were targeted at struggling private-sector businesses, these latest measures have been a more broad-based rescue that looks all too familiar in China. For one thing, the central government allowed local governments to ease housing restrictions and speed up the issuance of local-government bonds for funding infrastructure projects.
And for another — the business surveyor China Beige Book said in a recent note to clients — shadow banking came back with a vengeance in the second quarter, especially in China’s biggest cities.
“In Q2, banks retrenched and corporate borrowing fell a notch, but shadow banks returned in force to fill the vacuum,” the note said. “This quarter, firms reported the highest share of shadow borrowing as a share of overall borrowing in survey history. More shadow finance typically means more expensive credit — adding repayment pressure to the second half of 2019.”
The small banks
And then there’s the appraisal of China’s small- and medium-size banks now underway. Over the past few weeks, interbank lending for smaller banks — and subsequently for the small- and medium-size enterprises (SMEs) they lend to — has been in its own mini-crisis.
It started with the curious case of the Baoshang Bank bailout, China’s first public bailout in 20 years. Baoshang was a small, seemingly healthy bank that authorities took over in May. A bank run was avoided, but not all of Baoshang’s interbank liabilities were guaranteed. Suddenly people realized they could actually lose money as counterparties. A new kind of fear was injected into the market, triggering a liquidity crisis.
“The interbank run has lasted for over a month now and has probably been harder to control than policymakers had hoped,” analysts at Societe Generale wrote in a recent note to clients.
Policymakers have been touring regional banks to get a hold of this situation (a process that could take months) and say they’re focused on “supply-side reform” for all SMEs and the banks that lend to them.
“That means taking over small banks to keep them from going bust and reducing their loan quotas to give market share to the Big Five [state owned banks],” Anne Stevenson-Yang, the founder of the China-focused investment firm J Capital Management, wrote in a note to clients.
“The propaganda organs are working to persuade the public to avoid private financing. Nanjing Bank, for example, is conducting an ‘education campaign’ warning people to hold their wallets tight and not invest in ‘illegal’ — read, private — money-raising schemes,” she added.
In that way, pressure on smaller banks is giving China’s state sector more power and crippling its still relatively nascent private sector — that’s one problem. Another is the possibility that the run on smaller banks could spread to the wider financial system. Chu estimates that bad debt could make up as much as 20 to 25% of the sector. Societe Generale called this possibility “the source of under-appreciated risk for the global economy.”
The brevity of the respite that looser credit conditions provided to the Chinese economy worried analysts like Chu. She said credit stimulus started in July but wasn’t felt in the economy until the first quarter of 2019. That was bad.
What’s worse now is that it seems like the credit deluge is barely working. It’s not providing its normal year or two of stability, thanks in part to the trade war.
“We’ve really only had one strong quarter of credit and that’s not really enough to bring the economy back at this moment,” Chu told Business Insider in a recent phone interview. “If the trade war issue is not solved, [policymakers] will be more predisposed to play it loose with easing. If the trade war just goes away, they’ll be more like they are right now — which is pretty tempered with the easing.”
If the trade war goes away, China has a chance to fix its problem with small- and medium-size banks and target stimulus to ailing sectors of the economy. It could buy itself a year or two until the next crisis and figure out a way to restore the international financial community’s confidence to bring in outside cash.
If the trade war continues, all bets are off. China will have to figure out how to redirect its economy away from exports as fast as possible. It will need to ratchet up credit, increasing the risk of a debt crisis, and that may not even be enough to blunt the trauma of a forced restructuring of its economy.
“Is credit and restructuring binge going to be enough to fix that,” Chu asked. “Probably not.”