Why China May Need a Recession

The rail tragedy in Wenzhou that left at least 39 people dead may prompt China to embrace slower growth. What China might really need, however, is a recession.

No doubt a significant slowdown would be unwelcome among China's leaders. They have lowered the annual growth target for gross domestic product to 7%, but the imperative of creating jobs to avoid social unrest has meant real expansion has long outpaced official targets. China's contribution to global growth has been such that international investors shudder at signs of weakness in its economy.

Over the last few months, such concerns have risen amid growing debate over the full extent of debt in China's economy. Of particular concern has been the debt of local governments that built bridges, paved roads and erected luxurious new office buildings for themselves as part of the country's stimulus plan following the global financial crisis. The National Audit Office recently estimated those debts total 10.7 trillion yuan ($1.66 trillion), or about 27% of 2010 GDP.

Agence France-Presse/Getty Images

Workers clear wreckage of mangled carriages after a Chinese high-speed train derailed when it was hit from behind by another express last month in Wenzhou.

That may well understate the size of the problem. Hints by China's central bank put loans to local-government financing vehicles at close to a third of total bank loans or 14.4 trillion yuan at the end of 2010. The banks report very low nonperforming loans on this debt. But with much of it incurred with little regard for how it would be repaid, a sizable chunk is expected to turn sour.

China is hardly Greece: A full-blown debt crisis is unlikely. Economists peg total government debt at somewhere between 60% and 90% of GDP. But because of how the local debt is structured, only about 25% to 30% of China's public debt has to be serviced with public revenues, according to GaveKal-Dragonomics, a research firm. That, combined with strong growth and significant assets on the other side of the balance sheet, means the chances of default on a national scale are low.

Most loans are owed by one state-owned entity to another (a state-run bank). If the debtor defaults, the question is less how the market reacts, and more which arm of government shoulders the loss. If banks need to recapitalize, they will likely turn to the government for help, and get it either directly through injections into the balance sheet, or through public share offerings supported by state-owned enterprises. Either way, taxpayers foot the bill.

But the real concern is that China, in its eagerness to keep joblessness at bay, papers over the hole in the balance sheet of the banks or the local governments without holding anyone accountable for the whole mess. If bad loan decisions don't come with consequences, banks will end up taking a major step backward in their effort to operate on commercial terms, not political ones. Corruption or fraud that allowed local officials and the well-connected to pocket large sums of public largess won't be exposed. In that case, the immediate problem is fixed, but the emphasis on growth at any cost remains unchanged.

Social frustrations mount and burst into the open when flaws in the state-led growth strategy become public. An outpouring of fury on Chinese websites over the Wenzhou high-speed rail crash on July 23 is a case in point. Railway officials blamed the crash of a high-speed train into the rear of a stalled train on "serious design flaws" in the signaling equipment. The rail system was a centerpiece of the 2009 stimulus plan, but questions will now inevitably be raised as to whether the project prioritized spending over quality control, with lethal results.

Analysts already anticipate far-reaching consequences. In a report last week, Citigroup wrote that the rail tragedy might prompt the government to slow GDP growth in years to come, giving it "more time to fix the problems created by artificial fast growth."

What might benefit China more is a recessionary bust that clears the way for a new boom. Brad Jones, Asia investment strategist at Deutsche Bank, notes that between 1790 and World War I, U.S. GDP fell one of every three years, a "purge and renewal" cycle that ultimately laid the groundwork for U.S. economic hegemony.

China cleared out some economic deadwood beginning in the late 1990s with the reform of its state-owned enterprises and later entry into the World Trade Organization. But in more than three decades, the country's upward trajectory has been consistent to a fault, heightening the risk that an eventual downturn will prove cataclysmic, not cathartic.

"You can either have small, frequent recessions, or you have a big bang," says Mr. Jones. "You don't get to choose 'neither.' Economies don't work that way."

The risk that leaders in Zhongnanhai are all too aware of is that a recession tests the limits of China's political stability. But a bigger blowup down the line could easily surpass them.

Write to Peter Stein at peter.stein@wsj.com