China's credit-fueled growth gives reason to doubt market recovery

A look at China's debt-fueled growth figures shows we should be a lot less confident about the rest of the global economy and financial markets.

China engineered a 6.7 percent year-on-year growth rate in the first quarter the old-fashioned way: via a huge injection of credit. Borrowing increased at a stratospheric 58 percent annual rate in the first quarter, taking credit to a figure approaching nearly half of output in nominal terms.

That this money is going disproportionately into all the wrong areas — housing, manufacturing, infrastructure and state-owned companies — is a problem for China. Short term this has helped to stabilize Chinese markets and growth, but longer term it leaves China with more debt with which to reckon, more unneeded capacity to ultimately cut, and further away from its goal of an economy balanced more on domestic consumption and less on investment.

That China is going further down this road is also a problem for the rest of us. It is likely no coincidence that China's borrowing binge has come at the same time as a sharp recovery in global stocks and the price of oil.

On the broadest measure, nearly three times the credit was extended in China in March as in February. On a rolling annual basis it now takes more than five yuan of new credit to produce every yuan of new gross domestic product, more than when China opened the credit taps in 2009 to blunt the impact of the global downturn.

That rising ratio of new debt to new growth is a massive flashing red sign that the quality of investment, which wasn't high in the first place, is dropping. Investment and borrowing were particularly strong at state-owned companies, where efficiency is not, shall we say, a watchword.

China meets the "if something can't go on forever it won't" test. Certainly, China, with strong central control, has a lot more influence over how this plays out domestically than would be the case in Brazil or the U.S., but even on this there is a limit.

If we reflect on the key role that a stable China has played in the global financial market recovery after a rough January — itself largely caused by concern over China — then it is easy to grow worried.

"There is no bigger policy lever than this kind of credit injection," Wei Yao and Claire Huang of Societe Generale wrote to clients.

"The Chinese government was clearly giving growth all the attention in Q1, and now the question is how long it will maintain this undoubtedly unsustainable model. Surging home prices seem a sign of emerging asset bubbles, and if this credit push were to continue, there would be more dangers, including risks of capital outflows and currency devaluation."

Remember fears about capital outflows and yuan devaluation were a large part of the reason that stocks fell sharply worldwide in the early weeks of this year. If China continues in this fashion those risks rise. If, for whatever reason, it reverses course we could expect to see falls in commodity and energy prices, reflecting lower demand from China, and a big hit to the resource economies that have done well out of its growth.

Global investors in risky assets who are buying into the recent rally are thus betting that China either continues its current course of action or is very adroit in dismounting from the credit tiger. Neither outcome could be described as a sure thing.

Taking all this into account, two implications seem likely:

First, China's oft-voiced ambition to transition away from an economy heavily reliant on new investment in things like buildings, factories and infrastructure is not going to happen at anywhere near the speed required.

Second, if the Fed can't hike with China pouring on the credit it will have a hard time increasing rates at all this year, underscoring its diminishing control over the forces that shape the U.S. economy.