China is less likely to back Russia while facing troubles of its own

For all the focus on how Russia’s economy is in trouble, isolated and battered by western sanctions, China, its most important ally, faces serious tremors as well. No other major country is showing deeper sinkholes of economic trouble.

After building for months, financial stress emanating from the Chinese property sector has blown out to unprecedented levels in recent weeks, destabilising an already brittle economy and making it less likely that Beijing will aggressively support Russia’s invasion of Ukraine.

Unsure whether the troubled property developers are just illiquid and temporarily short on cash, or insolvent and unlikely to survive, big Chinese lenders are wary of extending new loans. Finding it difficult to raise money at home, the developers have been forced to borrow abroad at exorbitant rates. The spread between high-yield bonds in the overseas Chinese market and government bonds is now at a staggering 3,000 basis points, a level last seen during in the 2008 financial crisis.

Property is critical to growth in China. About 25 per cent of gross domestic product and 40 per cent of bank assets in China are tied to the property market, where estimates of the effective default rate on high-yield bonds are close to 25 per cent, a record high. Dependence on foreign capital is high, but in February foreigners sold off China’s local currency government bonds at an unprecedented pace, twice the previous monthly high.

These uncertainties echo the doubts that haunted the US financial system in 2008, when lenders could not tell which big borrowers would live through the crisis and credit markets froze. Chinese policymakers seem aware that they cannot afford confrontations that further destabilise financial conditions.

Liu He, the top economic adviser to Chinese president Xi Jinping, recently tried to calm the markets by addressing concerns about how the government is handling problems in the property sector, the regulation of big tech platforms, a surge in Covid-19 cases and more. His comments brought some relief to financial markets, but systemic risk in the property sector remains high.

The fact that credit growth in China continues to be weak despite central bank efforts to stimulate the economy may be an early-stage sign of Japanification. With its rising debt, shrinking population and market turmoil, China looks increasingly like Japan did in the 1990s. That’s when Japan entered a deflationary trap, as lenders became reluctant to lend no matter how much liquidity the central bank pumped into the system.

Total debt in China has tripled over the past three decades to nearly 300 per cent of GDP, the level hit by Japan around 1990, at the start of its so-called lost decades. China’s working age population started to contract in 2015, a step toward stagnation that Japan crossed in the mid-90s.

Fewer workers mean slower growth. Looking at data from 200 countries going back six decades, my research found 38 cases of a country’s working-age population shrinking for a full decade. GDP growth in those countries averaged just 1.5 per cent and surpassed 6 per cent in only three cases. All three were small nations in special circumstances, such as recovering from a crisis.

Strong economic growth is virtually unheard of when the working-age population is shrinking, which makes it highly unlikely Beijing can hit its growth target of close to 6 per cent, particularly when productivity is also declining.

Chinese state capitalism has been a success when the state was in retreat, but now it is on the march. The government is posing aggressive new regulations on high-productivity sectors such as tech and taking draconian steps to control the pandemic. Beijing’s campaign to limit Covid-19 cases to zero shielded much of the population from infection, but also left them vulnerable to new variants. Now these variants are surging, triggering new lockdowns under the “zero-Covid” policy. Economic activity including factory output and retail sales looks set to contract this month and next.

So the west faces a more vulnerable, and possibly less unified, eastern front in the new cold war than many global observers have accounted for. With an economy just one-tenth the size of China’s, Russia is in a state of financial peril without equal, largely cut off from the rest of the world. But to an extent that is widely under-appreciated, China faces perils too and risks great damage to its vulnerable economy if it does anything that cancels foreign capital. That means Beijing is likely to think twice before offering generous support to Russia or defying western sanctions against the war.

The writer is chair of Rockefeller International