While the biggest risk to the global economy is a sharp slowdown in China, a return to its excessive reliance on credit to stimulate growth increases the probability of a more severe correction in the longer-term, argue Mary Nicola and Will Ballard.

 

Like a runner on a treadmill that is speeding up, China appears to need ever more rapid credit expansion just to maintain the pace of economic growth.  The risk of losing its footing gets greater the faster it goes. At some point, China needs to slow the pace of credit growth and address the debt overhang, strengthen bank balance sheets and undertake the necessary structural reforms to transition to a more consumer-driven economy. However, those reforms have been side-lined for the moment, with the government targeting growth in what should be an achievable range of 6.5 to 7 per cent.

Faced with the risk of a sharp deceleration in the economy, the Chinese authorities have decided that short term pain for longer term gains can no longer be tolerated. Initially, reforms were deemed necessary given the structural imbalances in the economy — which in essence, are the result of excessive corporate leverage among state owned enterprises in heavy industries. The rebalancing efforts, however, led to weaker growth as they revealed the ramifications of the credit-fuelled boom. Local governments struggled to meet their refinancing obligations without government intervention, while some companies in industries with excess capacity, particularly metals and mining, faced defaults and downsizing. 

The March meeting of the National People’s Congress (NPC) confirmed the recalibration of the government’s strategy towards stimulating growth via investment. Already, the economic data is starting to reflect the change in policy. Newly-approved projects for investment increased nearly 40 per cent year-on year in the first quarter, compared to a 2.5 per cent average for 2015. Industrial production accelerated in March, as did investment and retail sales. The closely-watched official Purchasing Managers’ Index (PMIs), a broad measure of the economic health of the manufacturing sector, also rebounded in March and remained steady in April, while electricity production grew at its fastest rate in over a year. Asset prices have responded, with house prices near all-time highs in Tier 1 cities such as Beijing and Shanghai, forcing policy makers to reintroduce house price restrictions.

All of this comes on the back of acceleration in credit growth. The government is targeting 13 per cent growth in total social financing (TSF) for 2016, compared to 12.4 per cent in 2015.  In the first quarter, bank loans and TSF grew by 14.7 per cent and 13.4 per cent, respectively. 

Fragile foundations

The problem with credit creation now is that its impact on the economy has deteriorated. This is largely because capital has been directed to heavy industry sectors like steel, coal and cement where there is already a supply glut. Rather than dealing with overcapacity that could potentially result in significant job losses, the government is avoiding the problem by trying to increase demand. But adding more investment to these sectors means that the government will see diminishing returns.

We measure the credit transmission as the ratio of the renminbi (RMB) value of GDP created in a year versus the RMB value of net credit created over that same period. That ratio has significantly declined since 2011. 

The key difference between this investment growth strategy versus previous incarnations is that the central government has vowed to take on more debt on its own balance sheet. The credit problem in China is largely concentrated in the corporate sector; most of which is linked to local government investment vehicles and thereby local governments. The central government, however, has room to increase its debt: at the end of 2014, government debt-to-GDP was 57 per cent (including general government debt plus off budget activity, according to the International Monetary Fund (IMF)). But whereas a 3 per cent fiscal deficit had appeared sacrosanct to Chinese authorities, at this year’s NPC meeting they expressed their willingness to exceed that limit if necessary.

Even if the government takes on more debt on its balance sheet, it doesn’t mean that the troubled corporate sector will not continue to borrow. Total debt-to-GDP, as estimated by the Bank for International Settlements, is around 230 per cent, the highest level of any emerging market. According to the IMF about 160 per cent of this is corporate sector debt. While the size of the debt clearly matters, of greater concern is the pace of the credit growth. In 2008, China’s total debt-to-GDP was estimated to be around 140 per cent. 

For credit expansion to be more effective, China must allocate capital to more productive parts of the economy, including the services sector, higher-end manufacturing and research and development.  While it is too early to draw conclusions, the fact that some of the heavy industries are starting to become profitable in the last few months implies that the government is allocating capital towards areas where there is already excess supply.

Overinvestment is not an issue.  In fact, capital stock per worker in China is actually low - one fifth that of Japan or the US - which implies that there is more room for investment. There tends to be a positive correlation between productivity and the capital stock available to each worker.

However, if capital is not allocated efficiently, an even bigger debt problem is inevitable. In its latest Global Financial Stability Report, published in April, the IMF noted that debt at risk in China - borrowing by companies unable to generate sufficient earnings to cover debt interest payments - increased to 14 per cent from4 percent over the period 2010-15. The report also states: “Considering estimates of bank loans potentially at risk and assuming a 60 per cent loss ratio, potential bank losses on these loans could amount to 7 per cent of GDP”. 

While the IMF argues a loss equivalent to 7 per cent of GDP is manageable given existing bank and policy buffers, as well as the expected economic growth, we believe the impact would be significant on growth and market sentiment. With banks loan-to-deposit ratios nearing 100 per cent (Figure 2), borrowers could struggle to secure funding. 

Is a crisis inevitable?

The big question is what will be the longer-term consequence of the increased pace of credit accumulation in China. While a hard landing in the form of a significant deceleration in growth or even a recession is not our base case scenario, and we expect China will continue to muddle through its problems, the biggest risk for such a centrally managed economy is a major policy mistake. Also, markets would likely panic if non-performing loans suddenly doubled. 

It successfully managed a banking crisis in the late 1990s, by transferring non-performing loans to asset management companies to free up bank balance sheets and then recapitalising the banks.  Things have changed since then. Our view is that the real problem in a future banking crisis would be liquidity not credit. Credit growth needs to be funded from somewhere; either via depositors or the wholesale market. In China’s case, deposits are the main source of funding. For this to continue, depositors must have confidence that the government stands behind the banks. 

There is some debate on whether China has the firepower to deal with another banking crisis, despite its USD3.2 trillion of foreign reserves. The country’s ratio of money supply to foreign exchange reserves, seen as a proxy for potential capital outflows, is around 15 per cent, below the 20 per cent level the IMF considers prudent. Pessimistic commentators on China point to the $500 billion decline in reserves between May 2015 to March 2016, resulting from a depreciation in the currency. They would argue that if China were to see further significant capital outflows on the back of a banking crisis, the government may find itself unable to backstop it.

We believe China does have the ammunition to manage such an event, however. While the ratio of money supply to foreign exchange reserves is an important metric to monitor the pressure on capital flows, China still has a relatively closed capital account and has increased capital controls since March. The authorities have, for example, increased oversight on invoicing of imported goods, which has been a major channel in evading capital controls. They have also kept the currency stable in the last few months, which has also helped.

In the meantime, monetary policy will remain loose and interest rates will continue to decline to keep NPLs under control.

The Chinese authorities have bought themselves and some of China’s ailing corporate sector time through the recent shift in policy. The hope is that global economic conditions begin to improve during its latest phase of credit expansion, helping Chinese growth to become self-sustaining and for the authorities’ attention to return to the much-needed structural reforms. You can be sure, however, that an alternative, darker scenario is very much on the minds of Chinese policymakers. 

Investment implications

With the shift back towards prioritising growth in China, coupled with accommodative policies across the major developed markets, global risk assets are likely to be supported in the near-term. However, on a longer-term horizon it is prudent to consider a range of potential outcomes, including those where China is faced with a sharper slow-down in growth. As such, we are concerned about the outlook for Chinese equities in the medium to long term; particularly banks and lower-rated property companies, which we believe would be at the centre of any longer term issues. We also see an opportunity to be long US dollars against the Chinese yuan. Despite the troubles in the Chinese corporate sector, certain names offer good value opportunities in our view.  We think that Chinese investment grade corporate credit is likely to outperform broader Asian credit markets, particularly the property sector, as a result of supportive government policies. However, given the spectre of rising corporate defaults, investors should be extremely selective on companies rather than trying to ride a broad market rally. 

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