Economic commentators have often praised Chinese banks for the prudent lending policies that protected China from the excesses of the Western financial system.
That was then. Now is very different.
The recession that simultaneously hit Japan, Europe and the United States strongly reduced demand for Chinese exports, which account for a third of the national Gross Domestic Product. With unemployment rising and social unrest always close to the surface, the government needed to react quickly.
Simply raising consumption would not be enough. First, internal consumption in China, in terms of percentage of GNP, is less than half of the U.S. figure. Second, only a small fraction of the Chinese population can consume on the Western scale, and this is not enough to absorb the mountain of goods America and Europe no longer buy China’s silk road economic belt.
Only infrastructure investment, meaning housing, railways, airports, roads and the like, would permit spending on the scale required to compensate for the fall in exports.
China has in recent years made huge strides in infrastructure development, but it is still a command economy, meaning that major projects are funded and implemented according to a central plan. Running a massive spending package through the normal state planning process would have taken far too long.
So the banking system was chosen as the fast-track channel. Banks were told to lend, lend, lend, and lend some more. Convinced that the government would cover losses, the banks did just that, handing out close to a trillion dollars in new loans in the first six months of 2009.
That is over one fifth of the GNP within half a year. The money has gone to individuals, corporations, state-owned enterprises, real estate developers, and local and provincial governments.
Even with the greatest good will and talent, it would be hard to invest that much money in bona fide projects. Much of it has gone back into bank deposits, which pay interest rates higher than those due on loans. Another portion feeds into the stock market, which has risen over sixty percent since the lending spree began.
In other words, much of the money is either diverted or used in speculation. Even if it is actually invested in infrastructure, it is impossible to guarantee the long-term viability of the projects. And the longer the money spigots stay open, the less the value of such projects is likely to become, and the greater will be the share of total spending diverted to speculative activities.
With some differences due to local circumstances, the Chinese government is thus creating the same kind of speculative bubble as developed in the U.S. between 2002 and 2007, with the same consequences. The primary difference is that the Chinese bubble is inflating much faster than ours did.
The result, however, is likely to be the similar: a financial free-for-all for a year or so, followed by a wave of defaults, a stock market crash and an abrupt economic downturn, with the Chinese population left holding the bag.
The hope of the leadership may be that before such a crash occurs, Western economies will have recovered enough to start the Chinese export sector growing again. This would be a neat trick but is becoming less likely with each passing month. The Western consumer is tapped out and will not resume past free-spending ways for a long time, if ever.
The eventual bursting of the Chinese credit bubble will have a significant impact on the global economy. It will prolong the current recession, lower the price of energy and raw materials, and further shake up the world financial system. It shall also to quash any remaining notion that economic globalization was ever anything more than a very expensive mistake.
The psychological impact will be just as important. China is currently looked upon as the motor and hope of global recovery. If China succumbs to an acute case of the Western credit disease that it was supposedly immune to, current economic thinking will be left without any support.
Finally, the crisis in China will leave the United States without its preferred political and commercial partner of the last twenty years, and force a complete realignment of its trade and foreign policy.