China will have to sacrifice a portion of its growth if it wants to reduce its dangerous debt burden. Reducing credit growth will almost inevitably lead to an even higher reduction in GDP growth. This is a price the Chinese government is not yet prepared to pay, but it could be forced to act in the medium term if it wants to avoid a financial crisis.

In recent years China has become dependent on credit to generate economic growth. Before the global financial crisis, total credit extended to non-financials was 150% of GDP. Ten years later, this has grown to over 250%.

This would not be a problem if credit was extended to projects generating large profits or laying the foundations for future growth. However, the amount of incremental GDP being generated by one incremental unit of credit has fallen, suggesting that this is not the case.

This means that the risk of a series of defaults severely hurting the financial system has grown. The government recognizes the problem and has pledged to deleverage the financial system and contain risks.

That is easier said than done: over the past 30 years credit has mostly grown at a faster pace than nominal GDP, and since the two are highly correlated, both would have to fall considerably for them to converge.

Lower growth levels would not allow the Communist Party to reach its centenary goal of doubling the size of the economy from 2010 levels by 2020.

Policy priority

The leadership's concerns about the size of, and risks in, the financial system are publicly known. President Xi Jinping and other high-ranking officials have called the containment of financial risk a priority for 2018.

Referring to real estate markets, in which prices remain dangerously high relative to incomes in many cities due to an influx of credit, the recently retired head of the People's Bank of China, Zhou Xiaochuan, expressed the sternest warning. Zhou said that if action was not taken, China could have its own "Minsky moment'" - a collapse in asset values that follows a period of prolonged optimism (see CHINA: Local government debt risk survives reforms - February 26, 2018). Such a collapse could cause a wider crisis in which investors scramble to convert their assets into something stable.

In their speeches, many officials refer to "animal risks." The two most commonly mentioned are "grey rhino" and "black swan," which refer to foreseeable and unforeseeable events that can rattle financial markets.

The leadership seems to agree that action is needed to reduce the mountain of debt so that oversight can be improved, and to ensure that credit is not issued to finance speculative investments.

However, there is considerable pain associated with reducing overall leverage.

Paying the price

Reducing the level of indebtedness means repaying existing loans while borrowing less, allocating a smaller share of the budget to new projects and consumption and a larger share to servicing existing debt. This will reduce debt but diminish growth.

There is a much-hated name for this practice: austerity. In China, as anywhere else, first stabilizing and then reducing the ratio of credit to GDP will lower the economic growth rate considerably.

Historical data for GDP, money supply and 'total social financing' (the Chinese government's own measure of total credit in the economy) show credit and GDP moving in unison. They also show that the two measures of credit have grown faster than GDP.