This article first appeared in The Edge Malaysia Weekly, on May 2 - 8, 2016.

The Chinese economy has unambiguously recovered. The data for March and April shows across-the-board improvements in industrial production, fixed asset investment, retail sales, real estate prices, business and consumer confidence, exports, foreign direct investment and foreign exchange reserves. This seems quite impressive, but the recovery was sparked off by a massive easing of credit, which raises questions as to whether the inevitable speculative bubbles and imbalances will eventually destabilise the economy.

Clearly, it is time to rethink the nature of the risks that China faces and its implications for this region. What we need to do is to weave together the political, financial and economic policy trends to get an overall picture:

•    Policy and the economy: While there is clear evidence of an economic recovery, it is one which depends excessively on further policy support.

•    Financial: There is absolutely no doubt that speculative bubbles have multiplied across different parts of the financial sector and that these are potentially destabilising; and

•    Political risk and implications for policy: Thus, effective and carefully calibrated policy responses are needed to ensure the economy remains on a good track. But there are signs of a deepening power struggle that could distract policymakers and make it more difficult to secure timely and well-calibrated policy actions.

Consequently, our take is that there is indeed a growing risk of dislocations, especially in the financial system, unless vigorous policy corrections are made.

Where does the economy stand?

The monetary easing has been huge as seen in the explosion of credit and total social financing in the first quarter. Over the next few months, this monetary stimulus will help the economy gain further momentum. But the pattern of the last couple of years is now clear — without policy stimulus, the economy weakens. With stimulus, it regains some momentum, but bubbles or imbalances quickly appear, which then cause policymakers to cut back on the stimulus. Because of the strong headwinds created by excess capacity, declining profit margins and too much debt, more and more stimulus is needed to achieve a given boost to growth. It really is difficult to get the right balance on policy.

Policymakers had long resisted using monetary stimulus for fear of repeating the stimulus of 2009-2010 which had produced speculative excesses and bubbles. So, the fact that policymakers resorted to this option suggests a measure of panic on their part, probably because they saw that the economy was in a downward spiral that required urgent action. The problem now is that the financial risks created by monetary easing are indeed considerable, as we discuss below.

Financial risks are growing rapidly

Many analysts point to how China’s total debt has soared to around 237% of GDP in the first quarter of this year, compared with just 148% at the end of 2007. This level is much higher than the average for emerging economies of 175% of GDP. The speed with which China’s debt has accumulated is as concerning to them as the level.

Certainly, it is true that non-performing loans are rising rapidly, though off a low base. And it is also the case that bond defaults have been rising, including by state-owned enterprises. The International Monetary Fund is talking about US$1.3 trillion (RM5.06 trillion) of debt being at risk of default. Its latest Global Financial Stability Report estimates that debt at risk has risen to 14% of total debt in listed Chinese companies, triple the level of 2010, with potential losses of approximately 7% of GDP.

However, we believe that the government has the resources to contain the stresses in the banking and bond sectors, given that it owns the largest banks and has the financial resources to recapitalise them. It is thus better to go beyond such simple ratios as debt-to-GDP and examine the overall financial sector. When we do that, it appears to us that the issue is not so much the levels of debt as the financial distortions and bubbles that are rapidly emerging:

•    Property bubble in the offing in top-tier cities: New home sales increased by 64% y-o-y in March. Property prices in top-tier cities such as Shanghai and Shenzhen have soared in recent months, at rates that can only reflect a bubble. Property sales of 37 major Chinese developers rose an average 111% y-o-y and 107% m-o-m in March. Monetary policy easing certainly has something to do with this property surge: New bank lending to households reached a new record in March.

•    Bubbles are emerging elsewhere and they are scary: China’s commodity markets have gone ballistic. The turnover of commodities on April 20 was RMB2.9 trillion (RM1.74 trillion). Transaction volumes in the Shanghai, Dalian and Zhengzhou futures markets have tripled since last year in the case of commodities such as rubber and steel. The trading volume of steel rebar futures on one day a fortnight ago was more than a whole year’s worth of production.

•    The financial sector is seeing new speculative pressures: Peer-to-peer lending has taken off in China, but it does not appear that this sector has been well regulated. Total P2P borrowing for home deposits tripled to RMB924 million in January 2016 from its level in July 2015. An estimated RMB1 trillion of home sales are reported to have been at least partly funded by P2P entities. The same frenzied rate of growth is apparent in wealth management products whose value stood at RMB23.5 trillion in 2015 — an astonishing figure that is bigger than the economies of Germany, the UK and France.

•    Capital flight may have eased but has not stopped: The continued discrepancy between Hong Kong trade data and the trade data issued by the Chinese authorities points to mis-

invoicing being used by Chinese entities to push money out illegally. Anecdotal evidence from property markets all over the world attest to a rising tide of Chinese money. For example, the Bank of Canada noted that buyers from China accounted for one-third of all purchases in Vancouver’s housing market in 2015.

Political infighting could distract the leadership

In the past two months, we have seen a series of developments that suggest growing frictions within the political leadership. Much of this is centred on President Xi Jinping’s efforts to accumulate more power than his two immediate predecessors had enjoyed:

•    Xi’s supporters have been pushing for him to be awarded the status of being the “core of the leadership”, an honorific which his predecessor, Hu Jintao, did not seek or claim. However, political observers noticed that in the recently concluded National People’s Congress, few of the top leaders deigned to apply the term to Xi. Neither NPC chairman Zhang Dejiang nor the chairman of the upper house Yu Zhengsheng nor Premier Li Keqiang used the phrase. In his speech, Premier Li was careful to praise Xi, but only in a restrained way. Some political watchers have seized on the fact that Xi did not shake Li’s hands after Li’s speech as a sign of leadership tensions — Hu had always made it a point to do so with his premier at similar events.

•    This has not stopped Xi from seeking even more positions. Recently, it was revealed that he was now commander-in-chief of all military forces in China. This opens him up to criticism that he is seeking to elevate his position well above those of his colleagues on the Politburo Standing Committee (PSC) and adopt a profile that only Mao Zedong had enjoyed.

•    In a speech last September, Xi lashed out against the Communist Youth League (CYL), which is seen as the power base of both Premier Li and his mentor, Hu. He warned CYL officials to be less “aristocratic” and depicted them as out of touch with the ground. Since then, many CYL officials have reportedly been demoted and media outlets have launched further criticisms of the CYL. A fortnight ago, the CYL was told to curtail the activities of the university it had set up, in a further sign that its wings were being clipped.

•    There are also reports of clashes between Xi’s main supporter on the PSC, Wang Qishan, and Liu Yunshan, another member of the PSC seen to be a loyalist of Jiang Zemin, China’s pre-eminent leader until 2003.

It is not surprising that the run-up to the Chinese Communist Party’s congress in late 2017 should be marked by more intense political pushing and shoving. At the 2017 congress, the composition of the next generation of leaders to succeed Xi and Li should emerge, so the stakes are very high. Currently, one of the two leaders who appear to be in the running to take over from Xi is Hu Chunhua, who is associated with the CYL faction of Premier Li that is now under attack just as signs emerged that other leaders closer to Xi are now being promoted.

The political jockeying seems more intense than in previous periods — the risk is that the attention of the political leadership is now very much on such political issues rather than the economy.

What does this mean for China’s economy and Asian economies?

First, the economic recovery depends substantially on easier policies, but because easier policies are contributing to financial risks, they will have to be reined in, which would slow the economic recovery. It is thus premature for exporters to China to rejoice over a major recovery in Chinese demand — the rise in Chinese imports will not be sustained for long.

Second, one reason why global financial markets stabilised recently is because perceptions of Chinese risks have eased. As the financial distortions and speculative bubbles become more prevalent and the damage they pose more concerning, the risk aversion of global investors is likely to increase. This could lead to another round of capital outflows from emerging Asian markets, which would also hurt Asian currencies.

Third, risks to Asian currencies would rise all the more if growing risks in the Chinese economy precipitated another burst of capital flight out of China, depressing the Chinese renminbi and generating more speculation of a Chinese devaluation.

In short, the next few months will see the Chinese economy gain further momentum. But good news may not last as the financial distortions are likely to grow and cause some dislocations. Any uplift in Asian exports or financial markets is thus likely to be short-lived.

Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy

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