How A Chinese Economic Crisis Would Unfold

Improving Chinese economic data have many experts saying that the economy has bottomed out, and that the possibility of a hard economic landing is off the table.

Societe Generale analysts* expect Chinese GDP to increase 7.4 percent this year but think there still is a "non-negligible risk" of a hard landing in which GDP growth falls to less than six percent. Remember a hard landing refers to four consecutive quarters of below six percent growth - which is the minimum needed for a stable job market and to avoid "systemic financial risk".

In a new report titled "What If China Lands Hard?" SocGen's China economist Wei Yao writes that clients they surveyed expect growth of between 5.5 - 7.0 percent in the worst reasonable case. Yao thinks it could drop much lower to about 4 percent.

So what would could cause a hard landing? According to Yao, a major trade shock, inadequate government investment from Beijing, or a sharp property market correction prompted by tight policies could all send China's economy spiralling.

And how would this scenario play out? From Yao:

"Whatever the catalyst, the excess capacity in the manufacturing sector – estimated at 40% in 2011 by the IMF – would be exacerbated by a sharp growth slowdown. This would cut corporate margins sharply, making profits plunge, and triggering a downward spiral in domestic demand. Bankruptcies and unemployment would occur on a large scale, endangering financial and social stability.

One factor that could accelerate the downward spiral is the high leverage of China’s corporate sector, which exceeded 120% of GDP at end-2011 and has kept rising throughout 2012. As the crisis progressed, non-performing loans would undoubtedly rise beyond the capacity of local governments to contain them, as their fiscal resources dwindled.

Even in China’s (semi-) controlled system, banks could choose to freeze lending as a knee-jerk reaction, while the authorities rushed to draft a decisive response. The rapid development of the non-bank credit market in the last few years, especially shadow banking activities, has created a new vector through which a systemic liquidity crunch could take place. Capital outflow would likely ensue, stretching domestic liquidity conditions further."

Here's Yao's chart:

*Note: Attribution changed to reflect house call.