2016-10-24 10:10:34 | Telegraph (UK)
Euro 'house of cards' to collapse, warns ECB prophet Issing
Ambrose Evans-Pritchard
Telegraph: 16 OCTOBER 2016 • 4:51PM
The European Central Bank is becoming dangerously over-extended and the whole euro project is unworkable in its current form, the founding architect of the monetary union has warned.


"One day, the house of cards will collapse," said Professor Otmar Issing, the ECB's first chief economist and a towering figure in the construction of the single currency.


Prof Issing said the euro has been betrayed by politics, lamenting that the experiment went wrong from the beginning and has since has degenerated into a fiscal free-for-all that once again masks the festering pathologies.


"Realistically, it will be a case of muddling through, struggling from one crisis to the next. It is difficult to forecast how long this will continue for, but it cannot go on endlessly," he told the journal Central Banking in a remarkable deconstruction of the project.


The comments are a reminder that the eurozone has not overcome its structural incoherence. A beguiling combination of cheap oil, a cheap euro, quantitative easing, and less fiscal austerity have disguised this, but the short-term effects are already fading.


The regime is almost certain to be tested again in the next global downturn, this time starting with higher levels of debt and unemployment, and greater political fatigue.


Prof Issing the lambasted the European Commission as a creature of political forces that has given up trying to enforce the rules in any meaningful way. "The moral hazard is overwhelming," he said.


European Central Bank is on a "slippery slope" and has in his view fatally compromised the system by bailing out bankrupt states in palpable violation of the Treaties.


"The Stability and Growth Pact has more or less failed. Market discipline is done away with by ECB interventions. So there is no fiscal control mechanism from markets or politics. This has all the elements to bring disaster for monetary union.


"The no bail-out clause is violated every day," he said, dismissing the European Court's approval for bail-out measures as simple-minded and ideological.


The ECB has "crossed the Rubicon" and is now in an untenable position, trying to reconcile conflicting roles as banking regulator, Troika enforcer in rescue missions, and agent of monetary policy. Its own financial integrity is increasingly in jeopardy.


The central bank already holds over €1 trillion of bonds bought at "artificially low" or negative yields, implying huge paper losses once interest rates rise again. "An exit from QE policy is more and more difficult, as the consequences potentially could be disastrous," he said.


"The decline in the quality of eligible collateral is a grave problem. The ECB is now buying corporate bonds that are close to junk, and the haircuts can barely deal with a one-notch credit downgrade. The reputational risk of such actions by a central bank would have been unthinkable in the past," he said.


Cloaking it all is obfuscation, political mendacity, and endemic denial. Leaders of the heavily-indebted states have misled their voters with soothing bromides, falsely suggesting that some form of fiscal union or debt mutualisation is just around the corner.


Yet there is no chance of political union or the creation of an EU treasury in the forseeable future, which would in any case require a sweeping change to the German constitution - an impossible proposition in the current political climate. The European project must therefore function as a union of sovereign states, or fail.


Prof Issing slammed the first Greek rescue in 2010 as little more than a bail-out for German and French banks, insisting that it would have been far better to eject Greece from the euro as a salutary lesson for all. The Greeks should have been offered generous support, but only after it had restored exchange rate viability by returning to the drachma.


His critique will exasperate those at the ECB and the International Monetary Fund who inherited the crisis, and had to deal with a fast-moving and terrifying situation.


The fear was a chain-reaction reaching Spain and Italy, detonating an uncontrollable financial collapse. This nearly happened on two occasions, and remained a risk until Berlin switched tack and agreed to let the ECB shore up the Spanish and Italian debt markets in 2012.


Many would say the crisis mushroomed precisely because the ECB was unable to act as a lender-of-last resort. Prof Issing and others from the Bundesbank were chiefly responsible for this design flaw.


Jacques Delors, the euro's 'political' founding father, issued his own candid post-mortem last month on the failings of EMU but disagrees starkly with Prof Issing about nature of the problem.


His foundation calls for a supranational economic government with debt pooling and an EU treasury, as well as expansionary policies to break out of the "vicious circle" and prevent a second Lost Decade.


"It is essential and urgent: at some point in the future, Europe will be hit by a new economic crisis. We do not know whether this will be in six weeks, six months or six years. But in its current set-up the euro is unlikely to survive that coming crisis," said the Delors report.


Prof Issing is not a German nationalist. He is open to the idea of a genuine United States of Europe built on proper foundations, but has warned repeatedly against trying to force the pace of integration, or to achieve federalism "by the back door".


He decries the latest EU plan for a 'fiscal entity' in the Five Presidents' Report, fearing that such move would lead to a rogue plenipotentiary with unbridled powers over sensitive issues of national life, beyond democratic accountability.


Such a system would erode the budgetary sovereignty of the member states and violate the principle of no taxation without representation, forgetting the lessons of the English Civil War and the American Revolution.


Prof Issing said the venture began to go off the rails immediately, though the structural damage was disguised by the financial boom. "There was no speed-up of convergence after 1999 – rather, the opposite. From day one, quite a number of countries started working in the wrong direction."


A string of states let rip with wage rises, brushing aside warnings that this would prove fatal in an irrevocable currency union. "During the first eight years, unit labour costs in Portugal rose by 30pc versus Germany. In the past, the escudo would have devalued by 30pc, and things more or less would be back to where they were."


"Quite a few countries – including Ireland, Italy and Greece – behaved as though they could still devalue their currencies," he said.


The elemental problem is that once a high-debt state has lost 30pc in competitiveness within a fixed exchange system, it is almost impossible to claw back the ground in the sort of deflationary world we face today.


It has become a trap. The whole eurozone structure has acquired a contractionary bias. The deflation is now self-fulling. Prof Issing's purist German ideology has no compelling answer to this.




2016-10-24 10:10:34 | Telegraph (UK)
Standard & Poor's warns on UK reserve currency status as Brexit hardens
Ambrose Evans-Pritchard
Telegraph: 13 OCTOBER 2016 • 7:25PM
Britain is in danger of misreading the political landscape in Europe and faces the possible loss of its reserve currency status if it fails to secure full access to the European single market, Standard & Poor's has warned.


The powerful US rating agency said the British government is treading into hazardous waters in negotiations with the EU and is risks serious damage to economy's future growth trajectory, with long-term implications for the debt profile and the country's credit-worthiness.


S&P fears that loss of unfettered access to the single market would have incalculable consequences for business, yet the Government so far appears almost insouciant about this.


"There seems to be this view that 'we're a big important economy, the Europeans export a lot to us, so they have got to give us what we want', but is that really true?" said Ravi Bhatia, the director of sovereign ratings in charge of Britain.

「『我々』は大型で重要な経済だ、ヨーロッパ勢は我々に沢山輸出している、だから我々が求める物を引き渡さなければいけないんだ、という考えがあるようだが、それは本当に本当だろうか?」と同格付け機関を英国で率いるRavi Bhatiaディレクターは言いました。

"Individually most of these countries don't export that much to the UK, and were seeing a hardening of attitudes," he said.


Mr Ravi said Britain has limited scope for a spree on infrastructure projects and is walking a fine line on budget policy. "Before Brexit, the trajectory was planned fiscal consolidation, but we're no longer certain we're going to see that," he said.


"If they ramp up fiscal spending they'll get a stimulus and that is good in one way as it will help boost growth, but they have to finance that spending; it will raise the deficit, and the debt stock is already high," he told the Daily Telegraph.


Standard & Poor's stripped Britain of its AAA status immediately after the Brexit vote in June, slashing the rating by two notches to AA, although the move was well-flagged in advance. It described the vote as seminal event that would lead to a "less predictable, stable, and effective policy framework in the UK".


The agency will issue its next verdict at the end of this month.


Any further downgrade at this delicate juncture would be more serious, amounting to a red card on the Government's hard-nosed rhetoric and negotiating tactics


It is unprecedented for a AAA state to lose three notches in a matter on months.


Mr Bhatia said Britain will be deemed to have lost its reserve currency status - for the first time since the early 18th Century - if the share of sterling bonds in global central bank portfolios falls below 3pc, with a knock-on effect on the rating. It was 4.9pc at the end of last year.


"To be a reserve currency means that the world has trust in you and is happy to hold its savings in your currency. It creates a pool of available capital. If you lose this and sterling becomes just another currency, a key advantage is lost" he said.


The Office for Budget Responsibility originally expected the budget deficit to fall to 2.9pc of GDP this year but has gone back to the drawing board since Brexit. It is also launching a new "fiscal risks" report as part of a revamped charter.


The OBR now expects a radically different trajectory as weaker growth eats into future tax revenue.


If the Government goes ahead with a major spending boost on infrastructure schemes this could push the deficit back above 4pc of GDP, a level that might start to raise eyebrows given that we are at the top of the economic cycle.


This would imply a jump back towards double-digit deficits in a recession. Public debt is already 90pc of GDP, though it has been far higher at different times over the last two centuries.


There is no sign of a 'Gilts strike yet. Yields on 10-year UK debt have nudged up to 0.98pc on inflation expectations but are still lower than for comparable US Treasuries. The real test may come later once the Bank of England completes it latest round of bond purchases, worth £50bn. The Bank is in effect capping the yields artificially.


Mr Bhatia said Theresa May has proved to be a "relatively safe pair of hands" as Prime Minister but the Brexit vote has an inexorable logic of its own. The worry is that a hard outcome could set off capital outflows and expose the Achilles Heel of the UK financial system.


S&P said the level of short-term external debt coming due over the next 12 months is over 800pc of current account receipts, the highest of 131 countries that it rates. The figure is less than 320pc for France and the US.


Much of this short-term debt reflects the activities of banks operating in the City, many of them large foreign institutions. The liabilities and assets mostly 'net out'.


The immediate devaluation shock in June did not expose any serious mismatches in currencies or maturities but the concerns linger. Capital flight could take on a life of its own. "Things seem to be adjusting, partially due to the exchange rate, but the biggest issue is the absolute size of the external financing requirement," he said.


Britain has been running a current account deficit for years, settling at 5.9pc of GDP in the second quarter. This gap is funded by continuous inflows of foreign capital, leaving the country dependent on the kindness of strangers - or to put it more bluntly, at the mercy of very fickle foreign funds.




2016-10-24 10:10:33 | Telegraph (UK)
If Europe insists on a hard Brexit, so be it
Telegraph: 12 OCTOBER 2016 • 8:28PM
If the central purpose of Brexit is to restore the supremacy of Parliament, we should congratulate Labour for forcing a debate on the proposed terms of withdrawal. Let us demand that MPs should have a vote as well.


Brexit belongs to no faction. The referendum was not an election where the winner takes all. The circumstances are entirely sui generis and extremely delicate.


Both Scotland and Northern Ireland voted to remain, and the constitutional implications of this have yet to be confronted. A great majority of those below the age of thirty opposed Brexit, and many feel betrayed. It amounts to an inter-generational crisis.


The exact contours of Brexit were never defined. There was no Manifesto. The binary ballot presented to us on June 23 - nolens volens - contained not a single word about immigration. Many who voted to leave the EU want a liberal, amicable, open settlement with Europe.


It is the proper role of Parliament to discern the national will, and to impose its verdict on ministers. Theresa May is well-advised to bow to this imperative before Article 50 is triggered, even if raucous wrangling in the House greatly complicates negotiating tactics with Brussels.


That said, one must guard against certain vested interests in the City that are actively seeking to whip up hysteria in financial markets. There is an attempt underway to create a bad Brexit narrative in the hope of overturning it, or at least to frighten the country into a minimalist outcome that achieves much the same thing.


The interests of the financial elites should not be conflated with the national interest. A legitimate case can be made that they are in conflict.


Paul Krugman, the Nobel trade theorist, says the UK has been suffering from a variant of the "Dutch Disease", an over-reliance on finance that drove up pound and hollowed out manufacturing industries. This economic deformation has greatly enriched London's financial set and those who service its wealth, if non-one else.


There may be serious economic trials ahead as we extract ourselves from the EU after more than forty years, but the slump in sterling is not one of them. The devaluation is necessary and desirable. The pound is now near 'fair value' based on the real effective exchange rate used by the International Monetary Fund.


All that has happened is a correction of the extreme over-valuation of sterling before Brexit, caused by capital inflows. This left the country with the worst current account deficit in peace-time since records began in the 18th Century.


The fall is roughly comparable to the devaluation from 2007 to 2008 - though the same financial elites who talk so much of Armageddon today played it down on that occasion, mindful that their own banking crisis was the trigger.


We can argue over how much the 2008 devaluation helped but it clearly acted as shock absorber at a crucial moment. It was in any case a far less painful way to restore short-term competitiveness than the 'internal devaluations' and mass unemployment suffered by the eurozone's Club Med bloc.


But there is a deeper point today that is often overlooked. Central banks across the developed world are caught in a deflationary trap. The 'Wicksellian' or natural rate of interest has been falling ever lower with each economic cycle and is now at or below zero in half the global economy, a full seven years into the expansion.


This paralyses monetary policy and has dark implications for the next downturn. It is why central banks are desperately trying to drive down their currencies to gain a little breathing room, or in the case of the US Federal Reserve to stop the dollar rising.


By the accident of Brexit, Britain has pulled off a Wicksellian adjustment that eludes others.


With luck, the economy may even generate a few flickers of inflation, enough to let the Bank of England raise interest rates and start to restore 'intertemporal' equilibrium.


Personally, I have been in favour of a "soft Brexit" that preserves unfettered access to the single market and passporting rights for the City, but not at any political cost - and certainly not if it means submitting to the European Court, which so cynically struck down our treaty opt-out on the Charter in a grab for sweeping jurisdiction.


But what has caused me to harden my view - somewhat - is the open intimidation by a number of EU political leaders. "There must be a threat," said French president Francois Hollande. "There must be a price... otherwise other countries or other parties will want to leave the European Union."


These are remarkable comments in all kinds of ways, not least in that the leader of a democratic state is threatening a neighbouring democracy and military ally. What he is also admitting - à son insu - is that the union is held together only by fear. He might as well write its epitaph.


Mr Hollande and German Chancellor Angela Merkel invariably fall back on the four freedoms -movement, goods, services, and capital -enshrined in EU treaty law, as if they were sacrosanct.


These freedoms are nothing but pious shibboleths. They often do not exist, and where they do exist they are routinely honoured in the breach. Services make up 70pc of the EU economy yet account for just 22pc of internal EU trade. All attempts to open services up to cross-border commerce have been defeated, to the detriment of Britain.


The sorry saga of the Services Directive in 2006 tells all you need to know about how the EU works. "The French and Germans gutted it," said Professor Alan Riley from the Institute for Statecraft.

「フランスとドイツが骨抜きにしたんだ」とInstitute for Statecraftのアラン・ライリー教授は言いました。

The 'country of origin rule' that would have allowed firms to operate anywhere in the EU under their own domestic law was dropped, casualty of the "Polish plumber" scare. The directive did not cover health care, transport, legal services, professions, tax experts, and the like. Germany protected it guilds.

企業が自国の国内法に従ってEU内のどこででも事業活動が出来るようにするはずだった「Country of Origin Rule」は、「ポーランド人配管工」パニックの犠牲になって廃案となりました。

Online and digital trade across borders remains minimal, riddled with barriers. Britain's All-Party Parliamentary Group for European Reform concluded that "there is no single market in services in any meaningful sense."

英国の超党派グループ、Group for European Reformは「サービス業の単一市場は有意義な形では一切存在しない」という結論を出しました。

As Brussels correspondent I covered the parallel fiasco of the takeover directive. This too was sabotaged by France and Germany, after fourteen wasted years. They reinstated poison pills and a host of tricks in an explicit attempt to stop 'Anglo-Saxon predators' taking over their companies, even as their own companies were free to stalk British prey.


"It was disgusting," one Commission official told me at the time. Frits Bolkestein, the quixotic single market chief, was despondent. "It is tragic to see how Europe's broader interests can be frustrated by certain narrow interests," he said.


So much for the freedoms of capital and services. Nor has the free movement of people been strictly upheld. France and Germany - unlike Britain - blocked access to their labour markets and welfare systems for East Europeans for seven years after they joined the EU in 2004. It was political decision.


The four freedoms are really just aspirational guidelines, enforced when expedient, neglected at other times. The rigid exhortations from Paris, Berlin, and Brussels that there can be no free trade with Britain unless there is unrestricted migration - even after leaving the EU - is politics masquerading as principle. If they want to find a compromise solution, they can do so easily.


It is an odd spectacle. On the one hand the EU is so insecure that it talks of punishing Britain to deter other escapees; on the other it exhibits an imperial reflex, demanding submission entirely on its own terms, seemingly unable to accept or even to imagine a reciprocal trading relationship based on sovereign equality.


Mr Hollande wishes to bring about the hardest possible Brexit. If this proves to be the EU position - and it may not be, since it is lunacy and he for one will soon be irrelevant - it does at least clarify the issue.


A hard Brexit was never my preference. While the economic benefits of the EU customs union are greatly overstated, it would be no small matter to unwind the nexus of cross-border supply chains that has evolved over decades.


But if that is the only choice, so be it.




2016-10-24 10:10:31 | Telegraph (UK)
Britain should embrace weaker pound and it needs to fall further, says former BoE govenor and currency guru
Ambrose Evans-Pritchard
Telegraph: 10 OCTOBER 2016 • 7:54PM
The slump in sterling is a blessing in disguise after years of overvaluation and helps to break the corrosive stranglehold of the financial elites over the British economy, according to a former bail-out chief for the International Monetary Fund.


"It is desirable from every point of view. The idea that Britain is in crisis or is on its knees before the exchange rate vigilantes is ludicrous," said Ashoka Mody, the IMF's former deputy-director for Europe and now at Princeton University.


"The UK economy is rebalancing amazingly well. It is a stunning achievement that a once-in-fifty-year event should have gone to smoothly," he told the Telegraph.


Professor Mody, who led the EU-IMF Troika rescue for Ireland, said the pound had been driven up to nose-bleed levels from 2011 to 2015 by global property speculators and the banking elites acting in destructive synergy, causing serious damage to Britain's manufacturing base and long-term competitiveness.


The role of the City as the unrivalled financial centre of Europe made it a magnet for speculative property flows from Russia, China, the Mid-East, and the wider world, a bubble that was further leveraged by cheap dollar credit though global banks operating in London.


"It was essentially a bank-property nexus, and the rest of the economy was left to suffer. It is stunning that just 1.4pc of all loans were going to the manufacturing sector," he said.


The country was suffering a variant of the 'Dutch Disease', although in this case the problem was over-reliance on finance rather than commodities.


"Britain was borrowing 5pc to 6pc of GDP a year to buy imports and live beyond its means. The strong pound was great if you wanted to buy a Mercedes Benz of take a holiday in Spain, but the prosperity was an illusion, borrowed from the future," he said.


Prof Mody said the pound was 20pc to 25pc overvalued in trade-weighted terms before the Brexit campaign got underway, based on classic IMF measures of the real effective exchange rate (REER). This currency distortion would have inflicted deep damage if it had been allowed to continue for another five years.


"History is going to judge that Brexit at last broke the political-economy lock of a British elite wedded to banking interests, even if it happened completely by accident," he said.


Britain's current account deficit was 5.9pc of GDP in the second quarter, the highest in the developed world and has been flashing warning signals for years.


While views differ on the level of overvaluation, this chronic deficit is prima facie evidence of a misalignment.


Lord King, the former Governor of the Bank of England, echoed the comments on sterling, saying the sell-off was largely welcome.


"During the referendum campaign, someone said the real danger of Brexit is you'll end up with higher interest rates, lower house prices and a lower exchange rate, and I thought: dream on.


Because that's what we've been trying to achieve for the past three years and now we have a chance of getting it."


"I don't think we should fear [Brexit]. It's not a bed of roses, but nor is it the end of the world," he told Sky News.


Prof Mody said 'fair value' for sterling is around $1.10 against the US dollar, implying a further fall of around 11pc. "There is some likelihood that it is will overshoot and reach parity, but my reaction as a policy-maker is to ask 'what's the big deal'," he said.


The latest sell-off was triggered by the tough Brexit rhetoric from Theresa May and top ministers at the Tory party conference last week, dashing hopes for a compromise option that includes passporting rights for the City and full access to the single market.


Morgan Stanley has raised the likelihood of a 'hard Brexit' from 55pc to 70pc, but said it is still far from clear whether the Prime Minister can really persist with the current line given the bitter divisions in the country.


The US bank suggested that there may be a "technical fix" that would allow some form of shared decision-making with the EU without Britain having to submit to the European Court, as well as a fudge on free movement of workers through so-called 'economic work visas'.


David Meier from the Swiss bank Julius Baer said the conference rhetoric should be taken with a pinch of salt. "We have our doubts that UK officials really believe in what they are signalling.

スイスのジュリアス・ベア銀行のDavid Meier氏は、保守党大会での発言を額面通り受け取るべきではないと言いました。

A hard Brexit with loss of single market access would severely damage the economy and cause many firms to relocate into the EU market. We think Mrs May is simply rattling her sabre," he said.


The Chancellor, Philip Hammond, has so far kept a stiff upper lip. "Markets go up and down, markets respond to noise," he said, following the 'flash crash' last Friday.


"The important thing is to look through the movements of currency markets and short-term movements in sentiment," he said.


Simon Derrick from BNY Mellon said there is almost nothing they can do about it anyway – short of changing their Brexit strategy – since the Bank of England's total foreign reserves are just $173bn. This is petty cash in global finance.


Any attempt to defend sterling by raising interest rates would risk aborting the recovery, and might prove self-defeating in any case. "There is no line in the sand," he said.


Devaluations are never a panacea - and can have nasty side-effects - but in the short-run they act as a macro-economic stimulus and help the cushion economic shocks.


A weaker currency has lost its ability to frighten in a deflationary world where most of the major advanced states or economic blocs are trying to drive down their exchange rates to break out of the liquidity trap. Britain has inadvertently stolen a march in an undeclared global currency war.


For the fragile eurozone economy, the opposite dynamic is playing out. The pound is one of the largest components of the euro's trade-weighted index, and the 20pc fall since late last year has the side-effect of further tightening the deflationary noose.


The exchange rate has now fallen so far that most eurozone exporters selling into Britain can no longer absorb the currency effect by shaving their profit margins. They increasingly face the risk of declining sales and market share.


Prof Mody said eurozone leaders may be on thinner ice than they care to admit. "They are in a debt-deflation cycle, and it is self-reinforcing," he said.


French president Francois Hollande has now openly stated that his desired policy is to "threaten" Britain and make the country "pay a price". The more he succeeds, the more painful the blowback into France.




2016-10-24 10:10:30 | Telegraph (UK)
Chinese authorities need to guard against bad debt crisis
Telegraph: 2 OCTOBER 2016 • 5:32PM
It's time for another China disaster story. The world seems to have a decided appetite for them. Not long ago, attention focused on the Chinese stock market. Supposedly, the sharp fall in stock prices in the summer of last year presaged some sort of economic disaster.


As I argued at the time, it presaged nothing of the sort. Prices had risen sharply beforehand and were simply adjusting to a more realistic level. Since then, they have oscillated a bit but there has been no decided downward trend.


Other Chinese crash stories have centred on the fate of the residential property market and the foreign exchange market. Property prices have risen sharply over the years, but without prompting the general crash that many feared. In the foreign exchange market the central bank has tried to keep the currency competitive.


Earlier this year, however, there were massive capital outflows, prompting the central bank to sell huge chunks of its foreign exchange reserves for renminbi to prevent the currency from falling. There was widespread talk of a collapse of the currency regime. But it hasn't happened.


The latest scare centres upon the rapid growth of credit and the poor quality of many bank assets. It is widely feared that this will lead to large write-offs by the banks and possible insolvency – causing a crash of China's economy and possibly a world downturn. Are these fears any more justified than earlier ones?


To set the record straight, there is no doubt that the economy has slowed considerably from its breakneck rate of growth of a few years ago. The official growth figures say that the economy is expanding by just under 7%, but most seasoned observers believe that the rate of increase is in reality much lower.


The Capital Economics China Activity Proxy attempts to get a reliable gauge of activity by measuring real things such as electricity production and transport volumes. It puts current growth at about 5% but suggests that the economy may be picking up steam.


Admittedly, China suffers from several serious structural problems. Chief among them is the absurdly high rate of investment, which is pushing 50% of GDP. Since most of these increases to the capital stock have a low rate of return, at some point investment may fall back. If this happens suddenly, then the economy could fall into recession.


And then there is the problem of the banks. When an economy expands as fast as China has done – particularly when its financial sector is so ill-developed – there is bound to be a substantial amount of bad lending, which then leads to heavy exposure to bad debts for the banks. Interestingly, these problems have been known for a long time; it is just that more attention has recently been directed towards them.


Mind you, the scale of the problem is alarming. Chinese banks' non-performing loans are probably running at about 15-20% of the total. If all these were written off this would wipe out banks' capital base. And some estimates put non-performing loans as high as 25%, amounting to about 35% of China's GDP.


What the bears of the Chinese economy seem to fear is something like a Western-style banking crisis. Faced with the burden of bad debt, the banks will stop lending. Or, weighed down by their heavy debts, potential borrowers will refrain from borrowing. Through one or other of these channels, or both, the economic growth rate will plunge.


Some people compare this with the situation in Italy, where the proportion of banks' loans that are non-performing is just under 20%. But there are some marked differences between China and Italy. Most importantly, the Chinese banks are state-owned. Moreover, in regard to managing the banks and their debt problems, the Chinese government is absolutely sovereign, with no need to look over its shoulder to see what someone else thinks.


By contrast, in considering what to do with its broken banking system, the Italian government cannot simply stage a substantial bailout because this would infringe eurozone rules. Not only that, but the cost of bailing out the Italian banking system would add a huge amount to the already swollen level of Italian debt. In Italy, the ratio of government debt to GDP is currently running at 133%.


In China too it is likely that the government will have to bail out the banks, but the difference is that, not only does it have the will and power to act, but adding the cost of a bailout to China's debt would not create an insoluble problem. The ratio of China's government debt to GDP is currently about 55%. Adding another 35% would bring it to 90%.


Admittedly, this is high, but another key difference between China and Italy is that the Chinese economy is still growing pretty rapidly whereas Italy's is almost stagnant. If the economy is growing rapidly, then even a high debt ratio can be tolerable. It can be worked down as the economy expands.


China's looming bad debt crisis does, though, have a significant implication for economic growth, although not because of its effects on demand but rather because of its effects on supply. These derive from the serious misallocation of resources that is occurring across the Chinese economy. This will pose serious problems for China's potential growth rate in coming years. Until it seriously reforms its financial system, including the banks, thereby getting it to allocate resources properly, then investment will be misallocated into dodgy projects.


Accordingly, unless something changes, it is quite possible that in five years' time China's potential rate of growth could be 2%. After the heady expansion and lofty expectations of recent years, that would come as a considerable disappointment. Even so, in and of itself, lower growth would not amount to a crash. In any case, I think that something will change. The authorities will intervene, not just to write off bad debts, but also to reform the financial system.