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.
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.
In short, credit risks in China are rising. So will China crash? Unlikely. Households have healthy balance sheets (bank deposits made up more than 50% of household assets in 2014, according to Credit Suisse estimates) and China still has the world’s largest stash of foreign exchange reserves.
China’s currency reserves have shrunk by $400bn over the past year, official data show. Yet talk of panic capital flight from China is a red herring, in my view. This mostly reflects the rising US dollar (which shrinks the value of non-dollar reserves) and a switch by some onshore Chinese corporates to yuan financing rather than US dollars (a welcome trend).
The real problem? China is suffering a case of financial constipation. Crimped profits and rising overdue loans are pressuring the ability of the banking sector to allocate capital to where it is needed most. The majority of credit is being funneled into deadbeat borrowers refinancing their loans – not to the growth businesses of the future.
Debt service costs have risen to 15% of GDP – just short of record highs – according to Credit Lyonnais Securities Asia. Interest rate cuts are holding this ratio down. Yet more and more credit is required to keep up growth. This suggests monetary policy is losing its potency.
Will fiscal policy come to the rescue? More stimulus such as infrastructure spending could boost nominal GDP by up to 2.5% over the next two years, I estimate. Yet the effect could be muted given a reliance on local governments to implement spending plans.
The intensifying anti-corruption purge and arrests of prominent finance executives after the recent stock market crash have instilled fear in local government officials. The result could be policy paralysis.
Recapturing the spirit of optimism
Even the doomsday crowd in Hong Kong recognises two bright spots:
- MSCI’s inclusion of 14 Chinese firms listed in the US (via American depository receipts, or ADRs), including the e-commerce behemoth Alibaba, in global indices from November.
- The potential for a deal by mid-2016 on the Trans-Pacific Partnership trade agreement (this would exclude China but buoy Asian trade over time).
How to recapture the spirit of optimism? Tackling China’s bad debt – recognizing how much, who owns it, and how to restructure it – is the key. The trouble is this will take some time.