China is stepping up efforts to stabilise growth after it sagged last year to a three-decade low. But by piling more debt on an already highly leveraged economy, Beijing looks to be storing up problems for the future.
7 minute read
China’s economic growth rate fell to 6.6 per cent in 2018 on official measures, the weakest pace of expansion since 1990.1 Worse still, the slowdown looks to have intensified at the start of this year, with one state-run newspaper recently warning annualised growth could have declined to six per cent in the first quarter.2
The government has been forced to lower its growth target for this year to a range of six to 6.5 per cent – it had a harder target of “around 6.5 per cent” in the previous year. While activity has been weighed down by a decline in confidence due to rising trade tensions with the US, the bulk of the slowdown has been caused by China’s earlier drive to deleverage its economy and eliminate risky lending practices.
Stimulate or stifle?
Shaken by the stock market boom and bust of 2015 and the subsequent outflow of capital, Chinese policymakers’ initial response was to try to stimulate the economy. But by the middle of 2017 they applied the brakes once again in an effort to reduce financial risks.
That involved them trying to curb the debt of state-owned firms and local governments and cleaning up the banking sector by forcing lenders to recognise more of their bad loans. A new body – the Financial Stability and Development Commission – was established to strengthen coordination between financial regulators, while the banking and insurance regulators were merged.
Perhaps most significantly, policymakers launched an aggressive campaign to crack down on the country’s shadow banking sector, long viewed by the International Monetary Fund and others as the biggest risk to China’s financial stability.
Shadow banking, an array of loosely regulated and often opaque financing activities outside the formal regulated banking sector, has boomed over the past decade. Partly because deposit rates offered by China’s mainstream banks are suppressed by the state to help ensure a cheap source of funding for inefficient state-owned enterprises, the shadow banking system has attracted billions of dollars from savers who were attracted by the comparatively high returns on offer.
Those savings have provided a vital source of financing for private-sector companies. Many would otherwise have been unable to get credit since the risk-aversion of China’s major banks means they mainly lend to state-owned enterprises backed by central or local governments.
Rapid growth in shadow banking created two main problems. First, since the industry is largely unregulated, it lured less scrupulous operators. In some cases, savers were wrongly led to believe the products they were investing in were guaranteed by the government. A spate of failures in 2015 led to a series of noisy street protests and prompted Chinese President Xi Jinping in April 2017 to declare “financial security is an important part of national security”
Second, the boom in shadow banking was among the most important factors in driving total debt to a dangerous level. Since the financial crisis, debt has grown significantly faster than gross domestic product (GDP). The Institute of International Finance recently estimated China’s total debt-to-GDP ratio at 300 per cent, which is high even by the standards of most advanced economies.3
As a result of the crackdown, outstanding loans in China's shadow banking sector shrank 6.5 per cent to 61.3 trillion renminbi ($9.1 trillion) in 2018, following an even bigger fall the previous year, data from ratings agency Moody's show. While still equal to 68 per cent of GDP, it is down from a peak of 87 per cent at the end of 2016.4
However, the downside of this contraction is that many small firms in the private sector were starved of credit and borrowing costs for the remainder rose. Given the private sector is estimated to account for upwards of 60 per cent of China’s GDP growth and 90 per cent of new jobs, that took a heavy toll on the economy.5
A softer stance
By the middle of last year, with activity slowing faster than desired, Beijing eased back on its deleveraging drive and stepped up support for the private sector, seen as crucial to its hopes of stabilising economic growth. Stimulus measures included tax cuts to boost consumption and corporate profits, and various steps to increase the availability of credit, such as cuts in banks’ reserve requirements.
The government is also seeking to accelerate infrastructure spending, if only for now, since its long-term goal remains to try to rebalance the economy towards consumption and away from investment. More recently, the authorities appear to have acknowledged the squeeze on shadow banking went too far, eliminating not only high-risk speculative lending but more legitimate activities too.
Wang Zhaoxing, vice-chairman of the China Banking and Insurance Regulatory Commission, on March 10 told the South China Morning Post authorities were looking to soften their stance by distinguishing between “good” shadow banks and “unhealthy” ones, whose lending “doesn’t enter the real economy but only results in adding leverage”. 6
According to David Nowakowski, multi-asset and macro strategist at Aviva Investors, the easing of credit conditions, although typical of the stop-start manner in which Beijing has managed the economy in recent years, marks a dramatic about-turn in policy. It also illustrates the increasingly perilous tightrope policymakers are treading as they try to reduce leverage without badly harming the economy.
China has a longstanding goal of doubling GDP in the decade to 2020, and to turn the country into a “modestly prosperous” nation. Annual growth of about 6.2 per cent is needed in each of the next two years to achieve that.
Nowakowski says it is almost inconceivable China will not meet its objective, since the government will find a way to engineer extra growth if it looks set to fall short of target. “Front-loading some purchases or adjusting the GDP deflator are two of the more obvious tricks it has up its sleeve. Any de-escalation of the trade dispute between the US and China would also help,” he says.
However, while policymakers will continue to be tempted to prop up activity at any sign of weakness, that risks exacerbating the debt problem without doing much to boost the economy’s long-term fortunes.
Witness a series of policy initiatives both before and particularly after the financial crisis that encouraged debt-financed investment and the building of industrial capacity in ‘old economy’ sectors where none was needed.
“China has got a love-hate relationship with credit,” says Joanna Davies, senior China economist at Fathom Consulting. “It desperately needs to rebalance its economy and get debt down, but every time growth slows they rely on credit-fuelled investment as well as export growth. That simply exacerbates the long-term tensions.”
Looking further ahead, Nowakowski says Beijing is powerless to arrest an inexorable decline in trend growth. “Since liberalising its economy in 1978, China has had a lot of relatively easy wins – for example, investing in basic infrastructure and joining the World Trade Organisation – that will not be repeated,” he says.
China’s working-age population is also close to peaking. China’s population grew just 0.4 per cent in 2018, the slowest pace of expansion in nearly 60 years.
Although Beijing abandoned its longstanding ‘one-child’ policy in 2015 due to the worsening demographic backdrop, any impact from that decision will not be felt for at least 20 years. Recent data suggest it might be considerably longer, with the number of new births having last year fallen by two million – the second consecutive annual fall – to 15.2 million.7
“It is possible productivity gains could fill some of the void, but that would require the country to become more efficient by exposing protected sectors to foreign competition. That seems unlikely under Xi Jinping’s leadership,” says Nowakowski.
While China is much bigger and its economy more state-dominated, its economic development is arguably following a similar path to the one trodden by Japan and South Korea. They both recorded annual growth of 10 per cent or more in the 1960s and 1970s before the pace of expansion inevitably began to slow. “If their experience is anything to go by, annual growth of four per cent could well be a good result for China a decade from now,” adds Nowakowski.
Davies shares that view. She believes the economy could expand by as little as 4.6 per cent in 2020, “even if the official numbers don’t budge too far from six per cent”.
Storing up trouble?
Much as that may seem perfectly respectable relative to other nations, such a slowdown in growth, when combined with China’s high debt, could be a potentially lethal mix for companies, especially banks. After all, last year’s economic slowdown helped push Chinese commercial banks’ non-performing loan (NPL) ratio to a ten-year high of 1.89 percent.8 Worryingly, those numbers do not include other problematic and risky loans. Davies, who is in the process of updating her estimate, reckoned the true amount of impaired lending was just shy of 30 per cent in 2017, and rising.
According to a recent UBS report, Chinese banks ended the year with two trillion yuan ($420 billion) of bad loans on their balance sheets, up from 1.7 trillion yuan at the start of the year. That was despite selling 1.8 trillion yuan of non-performing debt to state asset management companies – vehicles set up by the finance ministry solely to house bad loans.9
According to Davies, Chinese banks’ non-performing loan ratio is high largely because funds are so often channelled into unproductive assets that do not earn enough to pay back the debt interest, let alone the principal.
There is little doubt China’s banks are weak and need recapitalising. Nowakowski and Davies agree that, while its state apparatus gives the country more ability to shape events than is the case elsewhere, a banking crisis would not be straightforward to fix. Unlike the banking crisis of the late 1990’s, China would not be able to grow its way out of the problem, while its banks have since been partially privatised.
However, although a banking crisis would undoubtedly be painful, China is different to most other countries. Not only does it not depend on foreign capital, its debt is mainly owned by its banks, which are in turn majority owned by the state. That makes it less vulnerable to the type of external funding pressures to have plagued other emerging economies in recent years. And it is unlikely to suffer a banking crisis of the magnitude seen in the West in 2008.
As for what this means for the rest of the world, although China’s economy is not especially open, with imports accounting for no more than 20 per cent of GDP, its size means it matters. According to Goldman Sachs, the country consumes around 30 per cent of the production of a basket of the world’s leading miners, while company filings show it accounted for 20 per cent of Apple’s sales and 14 per cent of Boeing’s in 2018.
Moreover, the scale of inward investment seen in recent years means trade data understate the significance of the Chinese economy. For example, with more cars sold there than anywhere else, China has lured a number of major automakers, including BMW, Ford and Nissan, to build plants there in recent years.
Since China’s economic expansion will outpace that of the West, it is likely to become an even more important market for many Western companies. Nonetheless, decelerating economic growth means few companies will be able to sustain current rates of revenue expansion.
Luxury goods groups are a possible exception since expectations point to China’s mega-rich continuing to swell rapidly. A 2018 report by management consultants Bain & Company reckoned Chinese consumers will account for at least 45 per cent of global sales of luxury goods by 2025.10
For now, the authorities will likely be able to guide the economy towards a slower growth trajectory while avoiding a major banking crisis. But it is necessary to recognise, with debt so high and the banking sector weak, Beijing has little margin of error.
The bottom line is China is not only unlikely to be able to come to the world’s rescue as it did following the financial crisis of 2008, it could trigger the next global downturn. While policymakers are likely to keep their balance for now, investors need to watch closely for signs they are slipping. As Davies says, with the economy increasingly “drunk” on credit, the risk of a policy mistake is getting ever more dangerous — for both China itself and the rest of the world.
- China GDP growth tipped to slow to 6% in Q1: state-run paper. Financial Times, 11 February 2019
- Institute of International Finance. Global Debt Monitor, 15 January 2019
- China shadow banking cools for first time in a decade. Financial Times, 18 March 2019
- China's private sector contributes greatly to economic growth: federation leader. Xinhua, 6 March 2018
- China to ‘strike a balance’ between good and bad shadow bankers to halt fall in growth. South China Morning Post, 10 March 2019
- China birth rate declines as childcare costs deter families. Financial Times, 13 March 2019
- China banks' bad loan ratio climbs to 10-year high at end-2018. Reuters, 11 January 2019
- China's banks have a $420 billion problem. The Canberra Times, 18 March 2019
- Bain & Company’s annual ‘Luxury Study’, published 15 November 2018