China’s next recession may be lurking on its balance sheets

China eked out 0.4% in GDP growth in the second quarter from a year ago. As much as authorities have tried to put a rosy spin on this news, the economy isn’t looking encouraging. A wave of mortgage boycotts is roiling the property market, a rural banking crisis is brewing, consumer demand is sluggish, and the government has yet to fully quit its disruptive zero-covid strategy.

The turmoil in Chinese markets has sparked debate among some economists over the possibility of a “balance sheet recession.”

What is a balance sheet recession?

A recession is a significant slide in economic activity across an economy. It’s typically defined as two consecutive quarters of decline in a country’s real GDP.

“Balance sheet recession” is a somewhat fuzzier term. It was coined by the Taiwanese-American economist Richard Koo to describe a situation in which household and business assets collapse in value. This severely damages their balance sheets, forcing them to save more while consuming and investing less, in turn causing an economic contraction.

Some economists, including Koo, argue that balance sheet recessions are particularly hard to recover from. In these events, monetary policy becomes largely ineffective, as those with precarious balance sheets refuse to borrow money, no matter how low interest rates are.

Still, there’s no readily agreed-upon definition of what exactly qualifies as a balance sheet recession.

“There isn’t a broad consensus about the concept,” said Vishrut Rana, an economist at S&P Global. “One piece of resistance from mainstream economists is that it ties in with other economic slowdowns,” which can make it hard to disentangle from other factors.

Is China facing a balance sheet recession?

Nevertheless, discussion among Chinese economists of balance sheet recessions has picked up in recent weeks.

A working paper published last month by the China Finance 40 Forum, a Beijing-based think tank, described domestic businesses’ damaged balance sheets. In particular, the paper explained, “many property developers are facing serious balance sheet problems” as a result of pandemic disruptions, excessive debt, limited growth, and regulatory tightening that has reined in developers’ freewheeling business models. Dollar bonds of Chinese developers fell sharply last week, while rising mortgage boycotts could unleash a vicious cycle, curbing property firms’ cash flows and causing them to default on loans and bonds.

“China’s macro economy is likely to experience a weak expansion in the face of balance sheet damage,” the paper’s authors wrote.

Beyond the shuddering real estate sector, China’s lopsided economic stimulus favoring infrastructure spending sprees over consumer demand also presents risks, argues François Godement, senior Asia advisor at Institut Montaigne, a French think-tank. “China faces the growing risk of a balance sheet recession, where low expectations curtail consumption and create a fiscal debt — and more debt,” Godement wrote in a policy paper last month.

Others say China is already in a balance sheet recession.

“We think China entered a balance sheet recession in Q2, and policy needs recalibrating to fix it,” Craig Botham, an economist at Pantheon Economics, wrote in a recent note. “The combination of the property downturn, tech crackdown, and zero covid, have hit asset values.”

Rana disagrees, arguing that China is not in a balance sheet recession. Nor will he wager whether a balance sheet recession is looming.

“In my view, the macroeconomic risks are restricted to the property development sector,” he said. “That sector is facing some sort of mini balance sheet…I wouldn’t say recession, but balance sheet crisis. But it’s localized to that sector.”

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