Broken pieces of China and the debt-driven growth model

Ewen Cameron Watt, Global Chief Investment Strategist at BlackRock, on China’s debt and how to recapture optimism.

China’s debt-driven growth model is on the skids. Economic slowdown, a freezing-up in trade, and plunging markets and currencies are casting a shadow across Asia – and the world. How worried should we be?

When I lived in Hong Kong in the 1990s, Asia was a place of great mood swings. Today is no exception, with pessimism fast on the rise.

’There’s no fun anymore,’ a leading shipping magnate summed up to me. China’s slowing economic activity has been with us for some time – and is reflected in falling commodity prices and China-exposed equities. What is new is global markets’ intensifying focus on China, enhanced by the US Federal Reserve’s recent emphasis on Asia weakness.

Below are some of my observations after a one-week trip to Asia talking to corporates, competitors, colleagues and contrarians.

Known unknowns

Everybody knows China has a debt problem. The hard part is getting a read on the size and distribution of the liabilities. Below are some key numbers, sourced from UBS this month:

  • Total debt (excluding the central government) stands at 210% of GDP, yet the headline figure is misleading. The bulk of this debt is issued by state owned enterprises and local government financing vehicles.
  • Non-performing loans (NPLs) in China stand at just 1.5% of GDP. Yet this low number disguises a number of fault lines. Recorded NPLs are rising at 30-45% per annum. Loans deemed overdue but not yet impaired doubled this year – a sign of negative corporate cash flows and further debt troubles ahead.
  • The official numbers do not include the biggest problem area: off-balance-sheet loans. Banks do not hold capital buffers against these loans; instead, they treat them as investments. Total bad debts in the system amount to around 11% of GDP, UBS estimates.
  • The problems are mostly concentrated in a few sectors saddled by overcapacity and changing regulations such as stricter pollution controls. Infrastructure (22% of bank assets), manufacturing (16%) and real estate (at a likely understated 7%) are the main offenders. Caveat: Debt in these sectors is likely worse than it appears. The official numbers only cover the on-balance-sheet exposures of 70 banks.
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