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IN HIS work on China s economy, Zhang Zhiwei observes what he calls the 5:30
rule . That is not the time he clocks off each day: he is a hard-working
economist for Nomura, a Japanese bank. But the rule does refer to a time of
reckoning of sorts. Mr Zhang points out that several economies have suffered
financial crises after their stock of credit grew by about 30% of GDP in a span
of five years or less. Japan fell foul of this rule in the latter half of the
1980s; America broke the limit in the years before 2007.
Now Mr Zhang is worried about China. At the end of 2008 total credit to firms
and households (and to non-profit organisations) amounted to less than 118% of
GDP, according to a new measure calculated by the Bank for International
Settlements (BIS). By September 2012 the total stood at over 167%.
It is natural for credit to deepen over time in a developing country. But when
credit departs too far from its underlying trend, trouble often ensues. Mathias
Drehmann of the BIS calculates that when the deviation exceeds 10% of GDP, it
serves as a reliable early warning of a crisis within the next three years.
According to our calculations, China s credit ratio now exceeds its trend by 14
percentage points (see left-hand chart).
Mr Zhang is hardly the only one perturbed by this gap. It was a big reason why
Fitch, a ratings agency, downgraded China in April. China s policymakers have
also taken note. In March the bank regulator urged banks to tidy up their
off-balance-sheet investments. Last month China s foreign-exchange regulator
cracked down on illicit capital inflows. And earlier this month China s central
bank stood by as interbank lending rates spiked in advance of the Dragon Boat
holiday (reportedly prompting one mid-sized bank to default on another). The
authorities seem keen to set a slower, steadier paddle-speed, hoping for less
splash and froth. In May the central bank s broad measure of total social
financing (TSF) at last slowed a little (see right-hand chart).
The other side of China s surging credit ratio is the surprisingly slow growth
of nominal GDP. In the first quarter record amounts were added to total social
financing, but growth was weak and inflation subdued. This wrongfooted both
optimists (who thought lashings of credit would fuel a strong recovery) and
pessimists (who expected it to fuel rapid inflation).
Ting Lu of Bank of America thinks this decoupling of credit, growth and prices
is partly a statistical illusion. The official measure of financing, he argues,
is marred by double counting. If a big firm borrows cheaply on the bond market,
then lends less cheaply to another company, the same money will appear twice in
the central bank s measure of TSF (an eclectic mix of loans, bonds, bills and
even some equity financing).
A deeper explanation, argues Richard Werner of Southampton University, lies in
flawed theory, not bad measurement. He revisited the link between credit,
growth and prices after moving to Tokyo in 1990, just as its bubble was
bursting. The years of overborrowing had many ill consequences. High
consumer-price inflation was not among them. Based partly on this experience,
he advocates a narrower view of credit s origins and a more discriminating view
of its purposes. Only banks can lend money into existence, he emphasises: their
loans create deposits that can then be used to pay for things. Other financial
institutions and instruments just transfer existing purchasing power between
parties. His definition of credit creation would exclude the non-bank loans
that have contributed so much to growth in TSF.
Debt fret
Mr Werner s second observation is that credit also serves different purposes.
Some is spent on consumer goods; some on creating new factories, buildings and
other physical assets; and some on assets that already exist. The first two
kinds of spending contribute directly to GDP, which measures outlays on freshly
produced output. But the third kind does not. Since these assets already exist,
their purchase does not add directly to production or inflationary pressure.
The economy does not grow or strain at its limits when an existing tower block
changes hands.
In bubble-era Japan a lot of credit was of this third kind. It was ploughed
into existing land and property, bidding up their prices to unsustainable
heights. In China this kind of lending is not easy to distinguish in the data.
But China does provide two different measures of investment. The first (gross
fixed capital formation) measures investment in new physical assets, which
contributes to GDP. The second (fixed-asset investment) adds in spending on
already existing assets, including land. In 2008 both measures of investment
were about equal. But spending on newly produced assets now amounts to only
about 70% of fixed-asset investment, says M.K. Tang of Goldman Sachs. This
suggests that existing assets are changing hands at a quickening pace and a
rising price.
How big a worry is that? Japan s bubble left a lasting legacy. Savers
discovered they were not as wealthy as their overpriced assets suggested.
Debtors found they were not as wealthy as their outstanding liabilities
required them to be. Banks retreated; animal spirits flagged. But credit booms
do not always end so badly, as China s own history shows. From 2001 to early
2004 total credit rose swiftly, violating the 5:30 rule. Towards the end of
this period the central government had to inject $45 billion into two of China
s biggest banks to help them weather their past lending mistakes. But no crisis
ensued. On the contrary, growth averaged more than 12% over the next three
years.
One difference between Japan and China s earlier boom is that China s state
stood behind the banks and many of their borrowers, whereas Japan allowed bad
debts to weigh on its banks and firms. China s less developed economy also had
more room to grow. Misguided loans and investments in the past did not inhibit
fresh loans and investment in the future. China has changed radically in the
past ten years. The hope is that even now it resembles Japan in the 1990s less
than itself a decade ago.