China: The Next Stimulus, the Next Debt Crisis

A debt crisis in China? Really?

Could be in the cards, write the folks at Wedge Partners today, arguing that slowing manufacturing activity in May will be followed by a second stimulus in August, and then debt issues at some point.

Certainly, the state of Chinese equities suggests some general economic concern amidst worries over the global economy: The Shanghai composite today closed up 1%, but it is down 4% this week and was down six of the past seven trading days, according to Dow Jones data. Since January 5th, the index is down 22%.

“Measures to cool China’s real estate market have put the brakes on the industrial economy and property markets in May,” write Wedge’s Asia research team.

“Answering the call is a new stimulus package, approved at the end of 2009 but scheduled to be revealed in detail in August. That seems likely to rekindle construction demand by starting up middle-income housing projects and light-rail construction.”

To give just one data point, the authors note that steel exports, “after a sudden jump in February, have gone back to 2009 levels.”

So now China is to follow its 4 trillion Renminbi stimulus from 2008 with an 8 trillion package that will start to flow in August, and the immediate effect will be to boost the economy: “We believe the stimulus package will raise demand for steel and building materials once more, as the government puts in place a construction program for lower-income housing. Rail projects also will get a new start.”

But the follow-on consequence could be a debt crisis. Quoting now, at length, from the bottom of Wedge’s note:

Political consensus in China supports the idea that the stimulus package worked. In theory, there is broad agreement that consumption growth would be healthy, but the government is too vested in supplying its own channels (heavy industry) with cash and in enjoying all the rewards of heavy capital investment to pay more than lip service to domestic consumption. Besides, domestic consumption has grown at a respectable rate, albeit from a low base. Still, it continued to shrink as a driver of GDP growth. Given a choice, a Chinese bureaucrat will always go for a steel mill over a candy store.

The stimulus measures are working. But it is equally clear that China is building up, someday, to a debt crisis that will rival the U.S. mortgage debacle. Lurking behind the excitement over a new 8T RMB stimulus injection is a well-founded concern over local government debt, in particular. Local governments typically are on the hook for about 65% of planned stimulus spending, and observers are rightly concerned about the potential sourcing of this capital and the impact it might have on the aggregate government fiscal health and sustainability.