The economic indicators from China have been turning negative for some time. For the first time, corporate credit spreads have begun to reflect the reality of underlying credit issues.
China has gone through a 25-year period of extraordinary growth, and in the process has transformed itself. A lot of the credit for this achievement has deservedly gone to Chinese policy-makers who have steered the economy with a steady hand and long-term vision.
But how sustainable is this breakneck growth? It is instructive to look at global precedents here—a study conducted by Credit Suisse in collaboration with academics from the London Business School has looked at GDP growth data since 1900. In these 113 years, it found that among major countries China’s record clearly stands apart, with an unbroken streak of eight per cent plus growth for 10 years. Only Singapore (in the early ’70s) and Germany (in its post World War II rebuild phase) come anywhere near this record, with eight years each of unbroken eight per cent plus growth.
Has China now reached a stage where its growth engine is faltering?
The rear-view mirror image
That economic growth is slowing in China is hardly news. The latest quarterly gross domestic product (GDP) print came at 7.4 per cent, and the falling trend is clear. However, the consensus on the street is that as in the past, policy-makers and the People’s Bank of China (PBOC, the Chinese Central Bank) have the situation under control and will be able to dexterously steer the country to an economic regime where growth will be lower but still robust.
This is a dangerous consensus, and in our opinion based on lazy thinking that the past history of policy effectiveness can continue indefinitely. There is certainly plenty of data to suggest an alternate view: that economic fundamentals of China have slowly been weakening over the last decade, that the next five years for China could be very different from the last 25, that central planners in China have potentially lost control of credit creation, and that there is a huge problem of mal-investment and excess capacity that will have to be shut down.
It has not been the first time that China has faced challenges to its continuing growth. In the aftermath of the South East Asian crisis in the ’90s, China witnessed rising net productivity levels (NPL) levels and had to resort to restructuring the balance sheets of its banks. But this time, the size of the looming crisis is much larger and possibly more difficult to control. A small but influential group of people in the investment world have increasingly started voicing their worries—George Soros, Marc Faber, Bill Gross of PIMCO, hedge-fund veteranJim Chanos and Harvard acad- emician Kenneth Rogoffare among the people who have issued warnings about China.
In our opinion, the time to start worrying is now, and the trigger could very well be the rising defaults emanating from the shadow banking sector... official policy is now that China will ‘allow’ defaults.
Too much investment can be a bad thing
The root of the underlying problem is irresponsible credit creation. In the aftermath of the 2008 financial crisis, Chinese planners realized the need to look beyond the export-led model of growth, and started the move towards a more domestic-led model. However, while the aim was to increase domestic consumption levels, the route taken was to ramp up domestic investment. A $586 billion stimulus program followed, and simultaneously the taps of credit were opened fully.
What followed was unprecedented. Ex-Fitch banking analyst Charlene Chu has pointed to close to $15 trillion of credit created in the banking system since 2009. To put that in context, this increase is roughly equal to the total stock of the US banking assets—China’s banking system has added the equivalent of the entire US bank balance sheet to itself since the financial crisis! This has also been accompanied by a big spurt in corporate leverage levels.
Even more worrisome is the ‘shadow banking system’, the moniker given to largely unregulated credit creation outside of the formal banking system. This has grown in less than 10 years from a virtually zero base to over 60 per cent of GDP currently. According to JP Morgan estimates, its assets increased 46 per cent year-on-year in 2013 alone.
So where has all this credit gone? It has resulted in excess investment and asset bubbles across various sectors in China and fuelled a property and infrastructure boom that has no equal in history. Cheap credit extended to unviable industries has led to steadily rising non-performing assets on bank balance sheets—NPL levels for Chinese banks are back to 2008 highs again.
The most egregious example of excess investment is real estate. According to J Capital Research in Beijing, China has added 5.9 billion square metres of commercial buildings between 2008 and 2012, the equivalent of more than 50 Manhattans. In 2012, China completed about two billion square metres of residential floor space equating to 20 million units and by 2013 end, around 6.6 billion square metres of new residential space was being built. This means China now has home ownership of over 100 per cent (some cities have over 200%) compared to 65 per cent in the US. And yet, a two bedroom flat in Shanghai is now more expensive than a comparable house in London.
Worryingly, reports that the Chinese property market is beginning to collapse are becoming increasingly frequent. China bulls who argue that the real estate problem would largely be localized and price falls can be contained easily by the government should look at precedents of Japan in the 1980s or US in 2006 (or for that matter Mumbai in mid-’90s).
According to J Capital Research in Beijing, China has added 5.9 billion square metres of commercial buildings.... yet, a two-bedroom flat in Shanghai is now more expensive than a comparable house in London.
The problem is now
So when will the Chinese credit bubble burst? After all, bubbles can continue to inflate indefinitely until the appearance of a trigger. What could form China’s ‘Lehman moment’?
In our opinion, the time to start worrying is now, and the trigger could very well be the rising defaults emanating from the shadow banking sector. In a couple of the initial well publicized cases (such as the China ‘Credit Equals Gold #1’ Collective Trust Product that redeemed in January 2014), the government’s agencies stepped in to prevent default. But increasingly, this will not be the case and official policy is now that China will ‘allow’ defaults. The first ever Chinese bond default of Chaori, a small Chinese solar cell maker, in March 2014 could be the canary in the coal mine. A spike in redemptions in shadow banking products is approaching in the next two years, and defaults in these may very well set the stage for an accelerating crisis.
The economic indicators from China have been turning negative for some time. Many real estate firms are already feeling the pressure of higher interest rates and dwindling buying interest. The increased volatility of the inter-bank rate—Shanghai Interbank Offered Rate (SHIBOR)—is also an important indicator, in our view, that lending markets are not functioning as smoothly. For the first time, corporate credit spreads have begun to reflect the reality of underlying credit issues.
How does this impact India and the world?
It is not difficult to imagine that a significant crisis emanating from China will cause severe market disruptions in Asia and the rest of the world. China is the dominant global buyer of commodities, so it is likely that this will be the first sector to be hit. Also impacted will be Asian banks and companies with exposure to Chinese construction or real estate. The hot foreign institutional investor (FII) flow into Asia would start seeing a reversal as investors start worrying about the Asian growth story and moving to the safety of the dollar—we are already seeing some signs of reversal in the carry trade.
Dependent economies like Australia, Singapore, Hong Kong and Japan are likely to experience immense pain as this situation plays out. Counter-intuitively, hedging against them may currently be the best way to hedge against China risk, as markets are yet to price fully the negative impact on these economies!