The recent gyrations on the Chinese inter-bank market underscore that the chief risk to global growth now comes from China. Make no mistake: credit policy will tighten substantially in the coming months, as the government tries to push loan growth from its current rate of 20 percent down to something much closer to the rate of nominal GDP growth, which is about half that. Moreover, in the last few months of the year the new government will likely start concrete action on some long-deferred structural reforms. These reforms will bolster China's medium-term growth prospects, but the short-term impact will be tough for the economy and for markets.
The combination of tighter credit and structural reforms means that with the best of luck China could post GDP growth in 2014 of a bit over 6 percent, its weakest showing in 15 years and well below most current forecasts. A policy mistake such as excessive monetary tightening could easily push growth below the 6 percent mark. Banks and corporations appear finally to be getting the message that the new government, unlike its predecessor, will not support growth at some arbitrary level through investment stimulus. The dire performance of China's stock markets in the past two weeks reflects this growing realization among domestic investors, although we suspect stocks have further to fall before weaker growth is fully discounted.
But the China risk is mainly of a negative growth shock, not financial Armageddon as some gloomier commentary suggests. Financial crisis risk remains relatively low because the system is closed and the usual triggers are unavailable. Emerging market financial crises usually erupt for one of two reasons: a sudden departure of foreign creditors or a drying-up of domestic funding sources for banks. China has little net exposure to foreign creditors and runs a large current account surplus, so there is no foreign trigger. And until now, banks have funded themselves mainly from deposits at a loan-to-deposit ratio (LDR) of under 80 percent, although the increased use of quasi-deposit wealth management products means the true LDR may be a bit higher, especially for smaller banks. The danger arises when banks push up their LDRs and increasingly fund themselves on the wholesale market. So a domestic funding trigger does not exist -- yet.