Worse than what you think?

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This article first appeared in The Edge Financial Daily, on November 5, 2015.

THE unreliability of Chinese official economic data has become almost a cliche. A few years before he became China’s premier, Li Keqiang said that the country’s numbers were “man-made” and “for reference only.” If the top economic policy maker of a country says that the numbers are not reliable ... well, you believe him.

But how unreliable? It is very hard to fake economic numbers in the same direction for a very long time — eventually, it becomes obvious to everyone that your economy is either much bigger or much smaller than the cumulative growth rates would have indicated.

Something a bit like this happened to China back in 2007, when the Asian Development Bank reported that China’s gross domestic product (GDP) was much smaller than believed. Chinese inflation had been understated, leading to real (inflation-adjusted) growth numbers that had been too high for too long.

In the current economic environment, the big question is whether China is suffering a deeper slowdown than is generally believed. The latest official numbers show a 6.9% growth rate — barely down from the recent 7% range.

Those are year-on-year numbers, of course. The real question, for investors and policymakers alike, is whether the numbers have been cooked.

The Chinese government has ample reason to fudge its growth rate on the high side. Growth has become almost a religion in China, and is now one of the Communist Party’s main sources of popular legitimacy.

Additionally, China’s leaders have an incentive to keep capital flowing into the country in the form of foreign direct investment, and to prevent capital outflows. That means heading off any incipient sign of panic. Economic number-fudging is a cheap way to prevent jittery investors from making a stampede for the exits.

Of course, knowing this, a number of people have tried to estimate China’s true growth rate.

The numbers range from Lombard Street’s pessimistic figure of a bit more than 3% to Bloomberg Intelligence’s optimistic number of just under 7%. In other words, there is a wide band of uncertainty here.

But I would like to suggest a scenario even more pessimistic than the lowest of the numbers above. After reading reports by Peking University professor Chris Balding on the state of China’s financial sector, I think there is a possibility that China’s growth is even lower than 3%.

Chinese electricity usage is growing at more like 1%. Rail freight traffic, though volatile, has suffered some dizzying drops in recent months. These are traditional proxies for heavy industry output. That they are barely growing, if at all, implies that much of Chinese industry has ground to a halt.

China bulls, of course, will argue that the country is merely in the middle of a transition from industry to services, and from wasteful power usage to greater efficiency. That is probably true.

But the speed of the transition would have to be incredible to make up for the precipitate drop in industrial activity. Why would China’s services sector and energy efficiency suddenly skyrocket immediately following the bursting of a major stock bubble?

One reason is government spending. A stealth stimulus is underway. But another big part of the equation is the financial sector, which has logged stunning growth in recent months despite the stock crash.

Why are Chinese financial services growing? Loan growth alone will not do the trick — banks need to be paid in order to log revenue. Or do they? Chris Balding reports: “[S]ome Chinese researchers ... compared the loan payments made by firms to the amount owed to banks ... [Their findings imply] that Chinese firms are paying only half the financial costs they should be paying ... The amount of revenue that banks are recording from loans is nearly four times the cost firms are associating with those loans ... [B]ank revenue [has been] outpacing firm financial cost growth by a factor of almost four.”

In other words, the amount of loan payments Chinese banks say they are receiving is a whole lot more than the amount Chinese borrowers say they are paying. If Balding’s numbers are to be believed — and of course, they are only one glimpse into a murky financial system — a large portion of the recent growth surge of China’s financial services sector may simply be fake.

That is in addition, of course, to the revenue Chinese banks are actually getting from “evergreening” (rolling over) of loans. That is an unsustainable process — although the revenue is real enough today, it merely pushes the day of loan delinquency farther into the future. So although this portion of GDP is not fake, it presages bad things to come.

All in all, China’s financial sector raises the possibility of a growth scenario that is far more pessimistic than official or private numbers would have us believe. Time will tell, of course. But I would not bet on a quick bounce-back of Chinese growth. At least, not a real one. — Bloomberg View