By Bob Cunneen, Senior Economist and Portfolio Specialist, NAB Asset Management
“It does not matter how slowly you go, so long as you do not stop.”
Confucius, Chinese philosopher (551 BC - 479 BC)
For investors, China provides questions with no final answers. As evidence points to China navigating towards a financial crisis, can you afford to be a passive investor and observer? Would China’s crisis be a temporary setback to the world’s largest economy?1 Or will this be a profound challenge to both China and the rest of the world? Are there any signs that a painful crisis can be avoided? Does China have the policy skills and tenacity to mitigate the risks? As much as investors desire the wisdom of Confucius to answer these questions, the financial reality is more ‘confusing’.
China’s real economic growth has been extraordinary by averaging almost 10% over the past 30 years.2 Yet recent years have witnessed a sharp slowdown with China’s economic growth, now running at 6.7%. The growth prospects for Chinese industrial production seem to be faltering. Excess capacity dominates China’s manufacturing and steel industries. Chinese exports appear to be struggling with the emergence of new competitors (eg Vietnam) targeting cheap products. China seems to lack the aspirational high-value products (eg cars and phones) to compete in the US and Europe.
Yet China’s credit growth continues to astound despite the slower economic growth. China’s bank lending is growing at a 13% annual pace which is twice the pace of real economic growth (see Chart 1). This rapid credit growth is a threat to China’s financial stability as well as the growth model. Credit has financed a surge in both Chinese capital investment and housing, but the efficiency of this resource allocation is being questioned. Credit seemingly is being allocated to marginal enterprises with limited prospects (“zombies” according to China’s Premier Li Keqiang) rather than emerging opportunities.3 Corporate profits are being squeezed with lower returns on investment and higher debt burdens. New debt is financing the old debt and various doubtful endeavours. Promises are being made rather than principal repaid. For creditors, they confront the spectre that their loan collateral is deteriorating. For Chinese banks in particular, the asset quality of their loan books is dubious. Credit defaults become more likely the longer this financial ‘shell’ game continues.
Chart 1: China’s bank lending vs economic growth
Source: National Bureau of Statistics (NBS), China and Thomson Reuters Datastream. Data as at 30 September 2016.
China’s credit boom is arguably a ‘credit bubble’ that rivals America in 2007 prior to the GFC. China’s total debt has surged from 150% of nominal GDP in 2008 to nearly 250% in 2015. Government borrowing only accounts for around 54% of this current 250% total, with household debt another 28%. The vast majority is Chinese corporate debt which now stands at 167%. This corporate debt can be further broken down to comprising private corporate debt of 68% and state-owned enterprises (SOEs are government-related enterprises) at 99% of GDP. The epic scale of China’s debt burdens are keeping trading partners and policymakers awake at night. Notably the Reserve Bank of Australia has expressed concern that a China credit meltdown and default cycle could pose “significant losses on financial institutions and could lead to a general loss of confidence and a tendency for liquidity to recede in a range of funding markets”.4 This seems to echo the calamitous ‘dash for cash’ liquidity crisis that marked the early stages of the GFC in 2007-2008. Notably the International Monetary Fund has already highlighted that China’s ‘corporate debt at risk’ could be as high as 14% of bank loans compared to the Chinese banks’ estimate of only 5% comprising non-performing and special-mention loans (see Chart 2).5
Chart 2: China: reported NPL and SML ratio, and debt-at-risk ratio
Source: People’s Bank of China; S&P Capital IQ; and IMF staff estimates. Note: 2015 debtat-risk ratio is last 12 months. NPL = non-performing loans; SML = special-mention loans.
Given China’s financial system is remarkably opaque, can we really measure China’s credit risks? There is the ‘shadow banking system’ of investment trusts and wealth management products that are not formally regulated or provide significant disclosure. The balance sheet of these ‘shadow banks’ is a mystery in terms of asset concentration, funding and capital adequacy. There are the ‘off-balance-sheet’ and ‘off-the-books’ transactions. While there are a range of estimates of the size of these ‘shadow banks’, the reality is that China’s total debt burdens estimated above are just that… estimates. China needs to communicate clearly and regularly on its financial system vulnerabilities. Otherwise, investors may consider that when the crisis does arrive, all of China’s financial system assets are impaired rather than just a select few. This could see China’s credit flows suddenly stop, causing a fire-sale of assets and mounting financial losses that parallel the GFC in intensity.
Even making China’s financial system stronger and more transparent may present a dramatic political dilemma. Should credit growth be constrained to make the painful long-term reforms that make economic growth sustainable? Or should credit growth be maintained to preserve employment and social stability? There is no convenient answer to this political dilemma, and China faces no easy or popular path between these two objectives.
However, China’s national government in Beijing does have the financial resources to manage or muddle through. Given that China’s corporate debt is largely related to SOEs and local government borrowings, it is ultimately a government burden. The loans are being domestically financed by China’s banks and ‘shadow banks’ where there is a similar significant government interest. So to mitigate a financial crisis, a decisive step would be deploying the Chinese government’s balance sheet to rationalise the debt burdens of these state enterprises and local governments. Notably a comprehensive debt rationalisation program would avoid a dangerous replay of the GFC where multiple vested interests failed to comprehend their interdependence (American investment banks and insurance companies, European banks, investors in collateralised debt obligations etc) while various policymakers struggled to give effective financial support (global central banks, government treasuries, financial regulators etc). China has the major attribute of the one government and thereby one authoritarian solution process for critical decision-making. Yet the time is ticking for China’s financial stability and the longer this credit boom persists the more painful the eventual reckoning will be.
1. ‘World Economic Outlook’, International Monetary Fund, October 2016. China is the world’s largest economy on the IMF PPP weights by accounting for 17.3% of global activity. This eclipses the US economy at 15.8% of global GDP.
2. World Bank data. China’s economic growth has averaged 9.95% over the period 1986-2015.
3. ‘Premier Li Keqiang vows to kill off China’s “zombie” firms’, South China Morning Post, 3 December 2015.
4. ‘The economic transition in China’, Assistant Governor Dr Christopher Kent, RBA, 16 June 2016.
5. ‘Global financial stability report’, IMF, April 2016.
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