China bears re-emerge from the wilderness as credit fears grow
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China bears re-emerge from the wilderness as credit fears grow

Fears are growing that China’s elevated debt levels, diminishing returns from its bank-financed investment-led growth strategy and slowing GDP prospects mean a credit crisis is in the making.

The debate about China’s economic outlook was given a new lease of life recently, with Fitch and Standard & Poor’s (S&P) offering diverging opinions on the sustainability of the country’s debt burden.

Charlene Chu of Fitch makes the case for the bears – downgrading the sovereign to A+, citing corporate leverage and off-balance-sheet lending – while S&P is more sanguine on the country, especially risks in the shadow-banking system.

From the outside looking in, China’s debt-fuelled rise indeed looks scary, especially in the context of the west’s own recent credit correction. Reasonable, if unspectacular, GDP growth of around 7.7% is being outstripped by credit growth that is running at more than 20%, levels that are unsustainable in the long term.

Meanwhile, the rate of return on capital is deteriorating rapidly, to around 12.5% in 2012, down from a high of nearly 16.5% in 2007, according to figures from Legal & General (L&G). What's more, figures released over the weekend suggest Chinese exports grew by just 1% in May from a year earlier, underscoring the risk the country will endure its second consecutive quarterly contraction.

Nevertheless, economists are mindful of the fact China has confounded its critics before. “Recall the late 1990s scare stories over bank debt crises – the government just mopped this up in the end,” says Vanessa Rossi, consultant and economic adviser to Oxford Analytica. “Although true, this was easier to do in those days.”

Many are quietly cautious about China, without wanting to stick their neck out by predicting an outright crash.

According to estimates from L&G, combined debt – incorporating household, corporate and government borrowing – is around 190% of GDP. That is modest in the international context: advanced economies average around 300% debt-to-GDP.

“The real cause for concern in China is not the absolute debt level but the speed at which it is rising,” says Brian Coulton, emerging markets strategist at L&G.

To put it into context, in the four-year period between late 2008 and late 2012, China’s stock of credit, excluding the financial sector, rose 57% of GDP. The US took seven years between 2002 and 2009 to increase the ratio by the same amount, with the UK debt-to-GDP ratio increasing by 80% in the same seven-year period.

The speed of China’s growth is not quite unprecedented, but the precedent is not a happy one. “These extreme rises of debt-to-GDP have been a very good predictor of financial crises,” says Coulton. “A lot of financial crises have followed this kind of credit expansion.”

There is no sign of any rise in non-performing loans (NPL) as yet, though many suspect Chinese banks are seriously under-reporting deterioration in asset quality.

According to the China Banking Regulatory Commission, the NPL ratio of Chinese commercial banks stood at 0.96% in Q1 2013, a nudge up from 0.95% in the fourth quarter of last year – the sixth straight quarter of rises since the fourth quarter of 2011.

Nevertheless, “there is no specific number or ratio that will serve as a trigger for NPLs to start rising and trigger a debt crisis”, says David Marshall, senior analyst at CreditSights in Singapore. “Many countries have much higher proportions of total debt-to-GDP than China does.”

If there is a bubble in China, it is not a typical one, with government interventions serving to distort the usual indicators – a fact that makes famed China bear Michael Pettis claim the Chinese banking sector is de facto insolvent without state subsidy of interest rates and political cover for asset quality deterioration.

Nevertheless, rising asset prices sit awkwardly with the bearish narrative that a China credit bubble could roil global markets. “In China, property is showing signs of overheating, but elsewhere prices are rising relatively modestly, mainly because the government is restricting it,” says Marshall.

The majority of the debt build-up is coming in the corporate sector. Here, debt-to-GDP is running at around 120%, though growing off-balance-sheet lending makes it hard to come up with accurate figures.

Falling corporate profitability, resulting from rising debt levels, could trigger increases in NPLs, but there is no sign of that on any substantial scale right yet, says Marshall. However, it does not take long for the tide to turn once the chain of events is set off.

The Chinese policymakers must tread carefully as the stakes rise as they continue their policy gamble: betting the short-term build-up of debt – through a financial system that favours investment over savings given financial repression – will pay off by boosting long-term growth capacity.

L&G’s Coulton urges caution. “The question is whether the government can have made sensible capital-allocation decisions at the speed investment is being made at,” he says.

With its labour market growth already slowing, China needs productivity growth of around 4% just to keep GDP growth at its current level, says Coulton. However, productivity growth is around 3.5% and has been falling, a trend that is unlikely to be reversed while the government keeps stimulating the economy.

As a result, to put itself on a more sustainable economic footing, China needs to increase consumption levels to help drive growth, decreasing its reliance on exports and investment-led growth, says Marshall at CreditSights.

Yet many believe that transition cannot occur without a sharp slowdown. “If GDP fell to 3% to 4%, that could be the trigger that sets off NPL rises and a credit correction,” he adds.

Coulton concludes: “We are not ringing the warning bell on China just yet. We are not anticipating a crash within the next year. There are notable mitigating factors to all this bad news, with the economy still generating a lot of savings, running a current-account surplus and good bank liquidity.

“Deposits in China are still higher than all the credit in the private sector, while the quasi-fiscal nature of much of the debt suggests the government may be able to manage it.”

However, it suggests China might have a bumpier adjustment than some are expecting, as it adjusts its economic growth level from the long-running average of around 10% to its 7% to 7.5% target. 

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