If the old illusion about China was that it was growing strongly then the new illusion is that it has the resources to stimulate its economy to maintain that growth.
Almost all of China's growth since 2008 has come from government-influenced expenditure. The Chinese growth story is reminiscent of the debt-fuelled US economy after the recession of 2001-02. China's headline growth of 8-10 per cent has been driven by new lending averaging about 30-40 per cent of gross domestic product. Up to 25 per cent of these loans may prove to be non-performing, amounting to losses of 6-10 per cent of GDP. If these losses are deducted, then Chinese growth is much lower.
As growth slows, Beijing's options to re-ignite growth are increasingly constrained. The weakness of its major trading partners, the US and Europe, means China cannot rely on its traditional strategy: export demand to drive growth.
Domestically, the side-effects of debt-driven investment are now emerging, as asset bubbles in property and shares burst. Cash flows from many investments will be insufficient to cover all the debt, increasing non-performing loans in the banking system. Resolving the bad debts will absorb a significant portion of Chinese savings and income. China is also left with a legacy of low-return investment, for example in infrastructure, which will create a drag on growth.
Difficulties in rebalancing between consumption and investment also restrict China's options. The conventional view is China will be able to stimulate demand using its large foreign exchange reserves, large domestic savings and low levels of debt.
China's $3.2 trillion in foreign exchange reserves are invested predominately in US dollars, euro and yen, primarily in the form of government bonds and other high-quality securities. These assets have lost value through increasing default risk (as the issuer's ratings are downgraded) and falls in the value of the foreign currency against the renminbi.
Attempts by the Chinese to liquidate reserve assets would result in sharp falls in the value of the securities and a rise in the renminbi against the relevant currencies with large losses. The reserves force China to buy more US dollar, euro and yen securities to defend the value of the existing portfolio, increasing the size of the problem and the risks.
China will ultimately have to write off these reserves, recognising its losses. This equates to a real loss of wealth as China has issued renminbi or government bonds against the value of these investments.
China also has far greater levels of debt than commonly acknowledged, although the bulk is held domestically. The central government has a low level of debt, about $1 trillion (17 per cent of GDP). In addition, state-owned and supported entities have debt totalling $2.6 trillion (42 per cent): local governments about $1.2 trillion (19 per cent); policy banks $800 billion (13 per cent); Ministry of Railways $280bn (5 per cent); and government-backed asset management companies set up to hold non-performing bank loans $300bn (5 per cent). The total debt, about $3.6 trillion, is 59 per cent of GDP.
China's real debt level may be even higher. Victor Shih, an academic at Northwestern University in the US, calculated that local government debt may be $500bn (40 per cent) or larger than the official figure based on analysis of local government documents and ratings agency filings.
