Our investment strategy assumes a slow rather than rapid return to normal, with a clear risk of relapse. Only when interest rates can be raised safely and the monetary gun reloaded, can we expect any return to normal. This process will take many years.
In recent weeks, investor attention has shifted back to emerging markets, in what appears to be a pattern of markets looking out for areas of indebtedness, which raises the risk of severe financial and economic stress: first it was US sub-prime, next the eurozone periphery and now the spotlight has shifted to unsustainably high debt levels in China.
With the investment share of China’s GDP estimated at close to 50%, bad debt risk is obviously high. Although the majority of investment is internally funded, the country runs a healthy current account surplus and has an arsenal of FX reserves close to 40% of GDP. This makes the situation different from a classic emerging market crisis, where an economy is forced into significant economic restructuring via devaluation.
A solution to the problem of China’s debt mountain will have to be worked out internally, although dealing with the misallocation of credit will mean slower GDP growth. The dilemma for the authorities is clear: rapid financial reform will hit growth in the short term, while reluctance to reform will hit longer-term growth prospects, making the problem larger.
If market forces are to be allowed a greater role in seeking out good investment projects, the end result may be more efficient investment, but at the cost of greater economic volatility.
This, after all, is what a normal market economy looks like.
