Major credit rating agency Moody's lowered China's credit rating earlier this week as a result of the nation's growing debt and waning economic growth. Alarm bells are ringing as this is the first time the agency has downgraded China in almost three decades.
Fears regarding China's ever-growing pile of debt have been recurrent: last year the IMF pressed Beijing to "urgently address" the issue.
The downgrade reflects Moody's belief that China's financial strength will inevitably begin to sap in the near future as a result of not only its debt crisis, but also slowing potential growth. These two factors will create an increase in contingent liabilities for the government.
The paradoxical situation of China's current economic problem is that while the government has injected millions into the economy through infrastructure, real-estate, corporate deals and high-risk insurance policies, it has done so using funds that are in the form of credit. This implies that the high growth at which China's previously booming economy has been experiencing is essentially artificially stimulated: it will need the same amount of debt-fueled investment to grow at a similar pace.
Yet, China cannot afford the accumulation of more debt. Therefore, because they are unable to maintain such high investment levels as they cannot obtain more credit, the economy will slow as Moody's predicts.
The origins of China's addiction to debt can be found in the 2008 financial crisis, when Chinese growth was the highest it had ever been before at a GDP of $4.558 trillion. As global growth wavered, China spent heavily building airports and highways, all of which was financed by debt. The country's debt has recently been increasing by a value equal to about 15% of the country's output each year, rendering economy expansion between 6.5 percent and 7 percent. Debt, by the same measure, barely changed from 2001 to 2008.
The accumulation of debt has also been aided by high-risk investments such as policies offered by companies like Foresea Life Insurance. Their products promised interest rates more than double of conventional bank accounts, incentivizing scores of ordinary investors. Foresea then took increasingly speculative bets, churning the money into real estate, corporate deals and China's mercurial bond market.
Yet, the Chinese government is trying to stabilize the economy and weed out dodgy investment methods. President Xi Jinping said: "Finance is the core of a modern economy. We must do a good job in the financial sector in order to ensure stable and healthy economic development." Regulators placed a ban on most of Foresea's new policies and expelled its chairman from the insurance industry, arguing that the company was essentially selling high-yield debt even though it had permission solely to issue low-risk life insurance.
However, China still faces the challenge of slowing capital stock formation as investment accounts for a decreasing share of total expenditure. Because monetary policy is restricted by the risk of stimulating renewed capital outflows, the burden of growth will fall on to fiscal policy, which increases the prospects of collecting debt as government spending needs to be funded by external sources.
It is a shaky path ahead for China, and a solution that is both balanced and insular must be adopted.
