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China's impossible trinity threatens economic slowdown

The Chinese Government faces a difficult dilemma — sacrifice some economic growth in the short term, or risk a debt-induced financial crisis down the track.

ANZ's chief China economist Raymond Yeung explains the problem.

"If President Xi Jinping truly prioritises reforms over growth, we must see more corporate defaults or foreign borrowing," he warned in a note.

"But if the Government does not want higher offshore US dollar debts, they must sacrifice some growth. They can't have all three."

He believes Chinese authorities will opt for lower debts, since China's foreign debt is already at a record high $US1.8 trillion.

Moreover, nearly two-thirds of this is short-term debt that will soon have to be refinanced in the face of rising US interest rates.

The combination of rising external liabilities and a weaker trade environment saw China post a rare current account deficit in the first quarter, its first since 2001.

But JP Morgan still rates China as one of the safer developing economies during the current period of US dollar appreciation that has unsettled many countries, notably Turkey and Argentina.

China has also had an addiction to non-bank "shadow lending", which companies and local authorities have used to get around Beijing-imposed controls on borrowing.

However, those authorities are now cracking down on this backdoor lending channel.

Short-term pain for longer lasting gains

As unprofitable Chinese firms that have relied on injections of cheap debt from overseas or domestic shadow banks find these funding sources drying up, many will face default and collapse.

Mr Yeung says that, in turn, is likely to see China's economic growth rate slow further to 6.3 per cent per annum.

"While this will be the lowest since the GFC, China's GDP will still expand sequentially," he said.

The slowdown means Australian exporters can expect to face tougher times later this year, with Chinese authorities also cracking down on highly polluting industries such as steel production.

However, Mr Yeung believes this mild, short-term pain will yield longer-term gains.

"We believe that slowing GDP growth is not a risk; the temptation to pump-prime the economy is," he said.

"Market sentiment will be poor. But targeting growth over reform will be worse, in our view."

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