Europe Turns to China—But Will They Regret Their Choice?

October 31, 2011 • Blogs, The Globalist Notebook • Views: 851

by Edmund Downie:

In case there were any doubts about China’s remarkable rise to geopolitical supremacy, this Friday’s events should have put them to rest. Top European officials have opened talks with China about the possibility of outside investment in the European Financial Stability Facility (EFSF), a bailout fund created last May to shore up the continent’s unraveling financial system. While China is just one of several emerging economies approached about investment, the visit of EFSF head Klaus Regling to Beijing on Friday, just a day after European leaders struck a last-minute deal that more than tripled the size of the fund, suggests that Europe’s hopes for China may be especially high.

Was it the right move? With the cost of the EFSF now at $1.4 trillion, Europe had little choice but to seek outside help. China, as its largest trading partner, was a natural fit.

But the timing of the decision is strange, as a number of events this October suggest that China may soon face an economic downturn of its own.

Start with Wenzhou. One of eastern China’s most prosperous cities is reeling after a wave of private bankruptcies in the past few months that have seen more than 90 executives go into hiding to escape mounting debts. The city’s troubles earned it a visit from Premier Wen Jiabao earlier in October, who used the opportunity to push a series of measures that would ease pressures on small- and medium-sized enterprises (SMEs) around the country. Meanwhile, a similar saga looks set to play out in Ordos, a resource-rich boomtown in Inner Mongolia whose real estate market is suffering a major slowdown after years of heavy speculation.

Wenzhou, one of China's most prosperous cities, has been hit recently with bankruptcies. (Bert van Dijk/Flickr Creative Commons)

In part, the struggles of Wenzhou and Ordos reflect the peculiarities of private enterprise in each city. Wenzhou has long been known as a hotbed of private entrepreneurship, a reputation gained in large part thanks to its vibrant informal lending sector. One local survey put the percentage of Wenzhou households involved in this form of lending at 89 percent (although bank regulators have denied this). These lenders are usually more friendly towards SMEs than larger banks (see below for why), but they charge exorbitant interest rates: often anywhere from 20 to 100 percent. Ordos contains a similarly large underground financing network, as well as absurd levels of property speculation. For instance, the Kangbashi New Central District, a sprawling 17-billion-yuan development meant originally to house one million residents, has drawn just 50,000 residents since its opening in 2006.

But to blame the loan defaults in Wenzhou and Ordos on local peculiarities is to deny the major imbalances in China’s banking sector that contributed to the crisis. Most of China’s major banks are state-owned and tend to favor large corporations with government connections. As a result, SMEs throughout China have no choice but to rely upon underground financing networks. Though Wenzhou and Ordos have particularly vibrant underground networks, they’re an important part of financing for firms throughout the country; statistics from Hong Kong-based research firm GaveKal suggest that nearly a third of all lending activity in China takes place through these channels.

For years, strong exports and high growth rates kept this system intact. More recently, a surging property market, fueled by the massive credit boom that followed upon the central government’s $586 billion stimulus in 2008, became the go-to destination for businesses looking for quick turnarounds on their investments. Now, however, with the global recession deepening, exports and GDP growth rates are both falling. Inflationary pressures have forced central authorities to tighten bank lending further, while property prices nationwide may soon see major reductions. Economists debate which of these factors have affected SMEs more, but it is clear that the current macroeconomic environment is putting them in a tough spot. In that context, the defaults seemed almost a formality.

It is important not to exaggerate the significance of the bankruptcies in Wenzhou and Ordos. Wenzhou is home to more than 450,000 private enterprises, only 80 of which have declared bankruptcy in recent months. Meanwhile, the coal and gas reserves that form the core of Ordos’s economy provide an important buffer against fluctuations in the city’s property markets. Few see in either city the seeds of a nationwide financial disaster.

On the other hand, Wenzhou and Ordos serve as useful windows into the debate raging among economists over China’s economic direction. Since the onset of the global recession in 2008, a number of economists and investors alike have questioned whether China is taking the right steps to deal with a depressed global market, expressing particular concerns over property bubbles, bad loans, and inflation. A recent report from French bank Société Générale identified China as the “world’s most crowded short.”

I’m no economist, and so I’ll leave the analysis up to those wiser than me. What I can say, though, is that the next few months will go a long way to answering our lingering questions about the state of China’s economy. On the one hand, the latest numbers indicate that inflation looks to be settling down. Consumption as a share of GDP has also seen modest increases, a good sign for China’s attempts to shift away from its export-heavy growth model of old. But a substantial fall in property prices could pose major problems for both the public and private sectors, both of which have relied on real estate as a key investment vehicle.

It is an awfully uncertain environment in which to be running a business in China. It is an even more uncertain environment in which to be begging China for investment—but such is the state of Europe. China has not yet agreed to supply those funds. In time, it may prove better for both parties if they don’t.

Edmund Downie ’14 is in Ezra Stiles College. He is a Globalist Notebook Beat Blogger on topics relating to China. Contact him at edmund.downie@yale.edu.

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