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There are signs China’s credit cycle has begun to turn, with big implications for other emerging markets, writes Will Ballard*.
China’s debt pile is huge – and getting bigger. The Institute of International Finance, an industry body, estimates China’s total debt stood at more than 300% of gross domestic product (GDP) as of May 2017. Debt has risen by 130 percentage points of GDP since the Global Financial Crisis, much faster than in other large economies.1
By loosening credit policy and implementing fiscal stimulus, President Xi Jinping’s administration has been able to meet its short-term GDP growth targets and pursue its longer-term objective of doubling the size of the economy by 2020. But China’s debt has grown to such a vast amount that the danger of a disorderly deleveraging process now seems very real.
In its latest Global Financial Stability Report, published in April, the International Monetary Fund (IMF) drew parallels between China’s debt-propelled growth and the situation that prevailed in the run-up to previous economic crises, such as Japan in the late 1980s and the US in 2007-09.
Meanwhile, Moody's Investors Services on May 24 hit China with its first sovereign debt downgrade since 1989 by knocking the country’s long-term local currency and foreign currency issuer ratings to A1 from Aa3.2 The ratings agency warned that China's financial strength will erode further, with debt levels continuing to rise and the country’s growth rate expected to decline to around 5% over the next five years.
For emerging-market equity investors, China’s debt mountain now resembles a Sword of Damocles dangling over their portfolios. But in fixating on China’s debt levels and the risks of an economic “hard landing”, investors may have missed a more pertinent danger. China’s credit cycle is starting to turn, with significant implications for investment assets across markets in Asia and beyond.
China’s growth trajectory is clear. The country’s GDP growth appears to be gradually moderating from the turbo-charged heights of the mid-2000s, when it regularly topped 10%, to a more sustainable rate in the 5-6% range.
Policymakers are nevertheless wary of growth dropping too steeply, and have been quick to take action when the economy shows signs of entering a slump. In the wake of the Global Financial Crisis, the government implemented expansionary fiscal and monetary policies, and in 2013 introduced a wide-ranging stimulus package – building railways, cutting taxes for small companies and channelling lending to export-oriented firms – when it appeared GDP growth was slipping below its target of 7%.
The government also took steps to liberalize the financial sector during the post-crisis period. This increased companies’ access to traditional loans and also led to a rise in so-called “shadow” lending. Banks teamed up with other financial institutions to shift loans off their balance sheets via wealth management products (WMPs).
Policymakers were initially relaxed about this activity, even though it enabled banks and insurers to circumvent rules over credit ratios and capital adequacy requirements – after all, it helped boost overall economic growth by extending credit to businesses that needed it to expand.
But the scale of the shadow-banking industry now has regulators worried. In its quarterly monetary policy report published in February, the People’s Bank of China (PBC) drew attention to the risks associated with banks’ off-balance sheet lending. The PBC also outlined new rules to stop WMPs from investing in illiquid assets and also moved to end the implicit guarantees that protected investors in these products, who often considered them no different from traditional bank deposits (albeit with much higher rates of return).
The clampdown on one particular insurance company in early 2017 served notice of regulators’ new, tougher stance. The firm had used its sales of WMPs to spur a highly-aggressive growth strategy in recent years, including the purchase of prestige assets abroad. Now the company has been forced to stop selling some of its more speculative products due to regulatory pressure, and its chairman has reportedly been detained by authorities as part of a wider anti-corruption drive.3
Turning of the credit cycle
Despite signs the government is growing more concerned about rising credit and opaque lending mechanisms, most investors believed it would continue to prioritize GDP growth over deleveraging until November this year, when the Communist Party convenes for its National Congress; reasoning that any economic slowdown would weaken Xi’s hand as he prepares to reshuffle the Politburo for his second five-year term.
The top-line indicators would seem to support this view. GDP growth continues apace – the economy expanded 6.9% in Q2 2017, comfortably exceeding the government’s target – and the overall debt burden continues to rise.
Nevertheless, a deeper look indicates that liquidity has begun to tighten considerably. Approximately RMB 1.1 trillion has flowed out of commercial bank investments with mutual funds and brokerages since April, according to PRC Macro, a consultancy. And interbank rates have begun to rise: the benchmark overnight repo rate in Shanghai has risen from 2.20% at the beginning of January to 2.75% as of July 20.4
Some commentators have deemed this latter change insignificant, because the PBC has hiked interbank rates far more quickly in the past. But given the rapid increase in China’s debt load in recent years, apparently minor shifts in money-market rates could be extremely significant. Smaller banks dependent upon wholesale funding will suddenly find it much more difficult to borrow, which may curb the flow of credit to companies in a range of sectors.
Broader credit growth has slowed considerably compared with last year, from an annual rate of 25% in early 2016 to just 15% as of May 2017.5 According to some estimates, credit growth – a measure often referred to as the “credit impulse” – fell by an amount equivalent to 17.5% of GDP over Q1 2017. A drop of this magnitude has only previously been recorded in 1994, 2004-05 and 2010.6
To be clear, we are not expecting the turn in the credit cycle to lead to a 2015-style equity-market correction, and the risks of a “hard landing” remain remote, at least for the time being. The government will likely aim to ensure the deleveraging process is as smooth and painless as possible. The PBC will try to strike a delicate balancing act, encouraging deleveraging in the financial sector while minimizing monetary deleveraging; that is, it is likely to continue to extend credit to commercial banks through its Medium-term Lending Facility while putting pressure on financial institutions to rein in shadow lending.
Over the long run, deleveraging is vital. By cutting its massive debt load, China will aim to make its economy safer and more resilient, and remove the Sword of Damocles from above investors’ heads. But there are likely to be some negative consequences. Chinese equities may suffer as cheap credit becomes more difficult to come by, and bond yields will probably rise as interbank rates are pushed higher.
The effects of the shift in the credit cycle should also be felt far beyond China. The country was becoming ever more closely entwined with the global financial system even before the introduction of the “Bond Connect” in June, which grants overseas investors more access to onshore credit markets, and the incorporation of Chinese A-shares into the benchmark MSCI Emerging Markets Index, which will take effect in 2018.
In its Global Financial Stability Report, the IMF warned “it is likely China’s spill-overs to global financial markets will increase considerably in the next few years.” So how will other markets be affected? With tighter regulation of WMPs and less debt-fuelled growth among state-owned enterprises, demand for commodities seems likely to fall, and this could affect export-oriented emerging markets in Asia and Latin America.
Recent history indicates how this may play out. Many commentators attributed Brazil’s economic travails in 2015 and 2016 to the corruption scandal engulfing former Brazilian president Dilma Rousseff, which eventually resulted in her impeachment. But the impact of a decline in Chinese demand for raw materials following its economic slowdown in 2015 was arguably more important. It is no surprise Brazil started to emerge from its slump when demand in China – its biggest trading partner – began to rise again towards the end of last year.
That resurgence also coincided with a recovery in global inflation. Indeed, the return of Chinese demand was arguably more of a factor in propelling a global rebound in commodity prices and inflation than the commonly-cited cause: the election of Donald Trump as US president, which investors hoped would bring less regulation and more fiscal stimulus. This shows China’s credit cycle is of relevance to developed-market investors too.
It is the emerging markets that have most to fear as Chinese credit growth slows, however. For the moment, commodities markets are holding up – give or take some softening in iron-ore prices since the beginning of the year. Nonetheless, emerging-market investors should keep a close eye on signs of weakening demand as the government’s deleveraging project proceeds. These signs will not necessarily be evident in debt and quarterly growth figures, but in less-obvious metrics: freight movement and electricity-generation patterns, for example, tend to be reliable indicators of industrial activity in China’s rustbelt.
As is often the case in China, investors will need to look past the headlines to the more granular detail that reveals the true story about the health of the economy. Xi’s government looks ready to turn the page to a new chapter of that story sooner than expected.
* Investment professionals are members of AIA/AIC's Participating Affiliate, Aviva Investors Global Services Limited ("AIGSL").
 “How serious is China’s debt problem?” UBS research, January 2017
 “Moody’s downgrades China’s rating from A1 from Aa3 and changes outlook from stable to negative” Moody’s Investors Service, May 2017
 “Anbang’s fall closes wild chapter in China’s insurance industry” Bloomberg, July 2017
 “What is China’s credit impulse telling us?” UBS research, May 2017
 “China’s credit squeeze sends warning on global growth” Financial Times, July 2017
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