Is China Setting Up for Lower Growth in the Medium-Term?

Recently in London, where I was analyzing the Eurozone and UK economies, I also had the opportunity to conduct a fairly holistic analysis of China’s real economy and existing imbalances in its financial sector.

Recently in London, where I was analyzing the Eurozone and UK economies, I also had the opportunity to conduct a fairly holistic analysis of China’s real economy and existing imbalances in its financial sector.

My analysis makes me rather apprehensive about China’s medium-term    (3-5 years) outlook and prospects – post 2017 – as there is a distinct possibility of growth falling below 6% (i.e. 5.5-6%) or China witnessing a protracted period of slow growth. However, I do not envisage a hard landing of the Chinese economy in the foreseeable future, due to several reasons stated later in this article.

Excessive debt likely to weigh increasingly on growth

What worries me most about China is that in spite of its surging and staggeringly high debt (i.e. total credit to the non-financial sector comprising of households, corporates and government, according to data from Bank of International Settlements, surged from 148.4% of GDP in 2008Q4 to a colossal 254.8% in 2015Q4) – as a result of the 4 trillion yuan stimulus package in 2009 following the global financial crisis and a credit binge (credit growth has outpaced nominal GDP growth in recent years) that resulted in a boom in investments in infrastructure, fixed assets and construction over the past few years following the crisis, massive lending to the real estate sector and substantial industrial overcapacity – and serious imbalances in its financial sector, China continues to rely on debt and investment fueled growth (particularly real estate investment and government led infrastructure spending) in 2016.

The underlying aim of such a growth strategy is to bring about short-term economic stabilization and achieve the officially targeted GDP growth rate of 6.5-7% growth in 2016 via a boost to domestic demand, rather than make more concerted efforts to rebalance the economy and undertake serious structural reforms for sustainable growth. As a result, China is possibly setting itself up for a bumpy ride and much slower growth in the medium term – post 2017.

Economic history inform us of the debilitating and protracted downside effects of surging and excessive debt on economic activity and growth; whether it was Thailand or South Korea during the Asian financial crisis (1997-1999), US or UK during the global financial crisis (2007-2009) or Greece, Portugal, Spain and Ireland during the Eurozone sovereign debt crisis (2009-2012) or Japan, existence of excessive private and/or public debt had a prolonged deleterious effect on overall economic activity (banking sector and asset prices) in these economies.

Further, at the zenith of the global financial crisis (2008-2009) and the Eurozone sovereign debt crisis (2011-2012), I was in London and Belgium respectively and witnessed how existence of significantly high levels of debt resulted in substantial impairment of the responsiveness of economic activity to monetary stimulus in the UK and Eurozone and restricted the ability of governments to launch more fiscal stimulus packages to stimulate growth – which has resulted in lingering tepid growth in these economies.

Turning to China, given its stupendously high debt, particularly high non-financial corporate debt (i.e. total credit to non‑financial corporations, according to data from Bank of International Settlements, surged from 98.6% of GDP in 2008Q4 to a massive 170.8% of GDP as of 2015Q4 and is much higher as a percentage (%) of GDP when compared to the US (71.2%), Eurozone (102.8%), UK (73%), emerging economies (97.9%) and Japan (101.3%)), the downward pressure on economic activity and growth from such debt is substantial and likely to act as an increasing drag on growth in the medium term – accompanied by lesser and lesser responsiveness of the economy to policy stimulus and higher fiscal deficit.

Pursuing high growth rates amid excessive debt will exacerbate China’s problems

What is equally disconcerting and where I believe that China is going fundamentally wrong is that it is pursuing growth rates that are too high (officially targeted GDP growth rate of 6.5-7% in 2016 and average annual growth of 6.5% during the period 2016-2020) at a time when it is mired in debt, facing industrial overcapacity and consumption and services sector are struggling to pick up the slack from a slowdown in investment and manufacturing.

In such a scenario, pursuit of such high growth rates would probably result in a rise in debt-to-GDP ratio (%) for at least four more years (enhancing the fragility of the Chinese financial sector, which is dominated by its banks), increase in banks’ non-performing loans, investment in projects with declining or lower returns, delay of serious restructuring of the economy, greater downward pressure on China’s currency (yuan), more turbulence, lesser and lesser responsiveness of the economy to policy stimulus, lower positive impact of a rise in debt on GDP growth and more and more capital being used to service debt, rather than for productive purposes. Further, given China’s total debt-to-GDP ratio of 254.8% (as stated before) and prevalence of excess capacity in real estate and infrastructure sectors, a stimulus based on heavy dose of credit, government funded infrastructure spending and real estate investment is not really sustainable in the medium-term.

It might be noted that China hopes to achieve the aforesaid targeted GDP growth rate for 2016 though a higher fiscal deficit ( i.e. by raising the fiscal deficit target to 3% of GDP, from 2.3% of GDP in 2015) and more rapid money supply and credit growth ( the government is targeting M2 (measure of money supply) growth of 13% in 2016, compared to the 12% target in 2015 and the aggregate social financing growth target for 2016 is at around 13%, following a 12.4% increase in 2015). This essentially means that credit growth will continue to outstrip nominal GDP growth resulting in worsening of China’s debt-to-GDP ratio.

Already, appallingly, credit growth was nearly twice of nominal GDP growth in China (with credit growing more than 13% year-on-year) in the first quarter of 2016. Further, in the first quarter of 2016, credit taps were opened and most of the new credit (around US$1 trillion) flowed into the real estate sector (which is the most highly indebted sector in China and accounts for around 15% of China’s real GDP) and a property bubble is being reflated mainly in China’s tier 1 cities (Beijing, Shanghai, Guangzhou, and Shenzhen) to support growth in the short term (though some measures have recently been undertaken to stabilize house prices). It might be noted that the real estate recovery in China this year is attributable largely to China’s loose monetary and credit policies.

Next, before I mention several factors due to which growth could fall below 6% in China in the medium term – post 2017 – it’s imperative to mention (in brief) the possible implications of a significant slowdown in China on other economies.

A slowdown in China could have serious repercussions for other economies

Given that China is the world’s second largest economy (accounting for more than 17% of Global GDP – according to Bank of England’s Quarterly Bulletin 2016Q1) and the largest trading nation (Chinese imports account for around 10% of global trade – according to Bank of England’s Quarterly Bulletin 2016Q1), lower growth over the medium term (post 2017) is likely to have serious repercussions for other economies, particularly for commodity exporting countries (such as Brazil, Australia, Canada, South Africa etc.) – as lower growth in China is likely to drive down prices of commodities (the current broad based recovery in commodity prices seem unsustainable to me in the medium term.

It might be noted that Chinese economic slowdown was one of the main reasons for the sell-off of global commodities over the past two years) – China’s main trading partners (such as Japan (whose outlook I am particularly worried about), South Korea, Germany, Malaysia, Taiwan and Singapore), several emerging economies and the entire Asia-Pacific region through confidence (business, investor and consumer), trade, credit, exchange rate channels and/ or supply chain linkages and also due to China’s rising stature in global finance (mainly through higher investments in financial instruments of other countries, substantial FDI and outstanding foreign loans and deposits).

Further, worries about China’s escalating debt could ripple through the global economy and spill over to global financial markets in the medium term, if unchecked, and might result in a substantial capital outflow from emerging markets (resulting in slower growth and tighter credit conditions in these economies) to save haven assets such as US Treasuries. Moreover, prolonged deleveraging in China could act as a significant drag on global economic growth.

Factors that could result in growth falling below 6% in the medium term

Next, stated below are several factors, due to which growth could fall below 6% in the medium term – post 2017 – or result in a prolonged period of slow growth:                                         

• Corporate Debt: reliance on massive expansion of corporate debt in China to prevent destabilization of economic activity and the financial sector and to support firms to prevent defaults will probably result in a rise in debt-to-GDP ratio for at least the next four years – which in turn is likely to increasingly weigh on growth. It might be noted that much of the rapid increase in corporate debt in recent years has been in the real estate, construction, commodity and energy sectors;
• State Owned Enterprises (SOE): mounting levels of debt in state owned enterprises and slow pace of reform amid falling profits poses a real threat or risk to the health of the Chinese banking system, credit availability to other parts of the economy and economic growth (as repayment of this debt will constrain other types of government spending) in the medium term.  What is worrying is that the SOE’s account for nearly 50% of bank lending in China. Consequently, bank balance sheets are coming under increasing stress. SOE liabilities as a percentage (%) of GDP is simply unsustainable and too high when compared to other countries, for example, Japan and Korea;
• Local Governments: spiraling debt of local governments is worrying as it gives rise to concerns about the health of the banking sector – considering that most of the debt is owned by local governments to state owned banks in China. For a perspective, according to the Ministry of Finance, local government debt was 16 trillion yuan at the end of 2015 and in terms of local GDP; local government debt amounted to 89.2%. There are rising risks with reference to local governments’ ability to repay debt.  The local government debt swap program to restructure the liabilities of the highly indebted local governments (by replacing high interest debt with low interest bonds) only reduces the interest payment costs and is really pushing the debt problem down the road. This is because such swaps don’t forgo the debt and consequently only make a small difference to the overall liabilities of local governments. As a result, local governments are likely to have very little financial power to spend in the near future to fund new projects – which in turn would be detrimental for growth;
• Deleveraging: deleveraging by firms, which are already highly indebted, over the next couple of years is likely to weigh increasingly on or act as a drag on growth. Further, China’s currency (yuan) may come under more downward pressure, while the economy deleverages;
• Non-Performing Loans: China’s state owned banking sector is struggling with rising non-performing loans at a time of diminishing profitability – which is reflected in return on assets (ROA). Further, rise in defaults, industrial overcapacity amid a slowing economy, high and rising corporate leverage and falling profits in SOE’s adds to growing concerns about bank profitability and profit margins and further rise in non-performing loans. For a perspective, according to IMF’s Global Financial Stability Report (April 2016), the reported problem loans of banks total US$641 billion or 5.5% of bank loans or equivalent to 6% of GDP. However, according to the IMF (in the same report), 15.5% of total commercial banks’ loans to companies were potentially at risk at the end of 2015 – an amount equivalent to US$1.3 trillion;
• Debt-For-Equity Swap: the debt-for-equity swap for dealing with the massive corporate debt problem and problem loans in the banking sector could actually result in weakening the banking sector and Chinese banks being saddled with stocks, which have hardly any value. Further, such swaps could affect liquidity of banks and leave them strapped for capital – with repercussions for the wider economy. Essentially, what debt-for equity swap could mean is simply that the risk is transferred from the corporate sector to the banking sector. Further, debt-for-equity swap could also result in propping up businesses, which otherwise would have failed. Moreover, such swaps may be acceptable in the short-term, yet over a longer term it will enable the corporate sector to issue even more debt, as corporate balance sheets would be freed up;
• Real Estate and Construction Sectors: if there is a significant slowdown in real estate and construction sectors in China, it is likely to widely affect other business sectors such as manufacturing and transportation and have considerable lagged negative spillovers – adversely affecting growth in the medium term. Further, the deep linkages of the real estate sector with the financial sector represents a major risk to China’s economic outlook in the medium term;
• Recapitalization: China is facing a serious problem of non-performing loans and continued expansion of credit amid a slowing economy that could result in substantial losses, which in turn would necessitate recapitalization of Chinese banks – dragging down growth further in the medium term;
• Bond Market: the Chinese bond market has been witnessing rising yields and widening risk spreads as concerns about defaults grow. If this is sustained, it could have a negative effect on the economy and the banking sector – resulting in downward pressure on economic growth. It might be noted that corporate bond issuance has surged, as companies increasingly turn to the bond market to meet their borrowing needs. However, concerns of financial stability are rising as bond issuance is taking place at a time of high and rising corporate leverage, increasing number of company bond defaults and rising balance sheet weakness;
• House Price Bubble and Financial Stress: house price bubble in China (as reflected in latest data), mainly in big cities (as stated before), and elevated financial stress among real estate firms undermine this sector’s medium-term outlook ( the real estate sector accounts for around 15% of China’s real GDP). Deflating of this bubble would have a downside impact on household consumption (as more than 50% of household assets are tied to property in China), and also result in a further rise in corporate debt and banks’ bad debts – posing a risk to financial and economic stability and growth in the medium-term. It might be noted that China’s real estate sector is witnessing declining return on assets and deteriorating financial health;
• Excess Capacity: there is existence of substantial excess capacity in manufacturing, steel, energy and real estate sectors. Given the current economic strategy of the government – using stimulus to support growth in the short-term (which has its limits) rather than focusing on serious structural reform – reduction of excess capacity in these sectors is likely to be too slow. As a result, rebalancing of the economy towards consumption is likely to be slow, which in turn could have serious repercussions for bank balance sheets and economic growth in the medium term. It might be noted that many non-performing loans of banks in China are concentrated in lending to these sectors (stated above);
• Underdeveloped Bond and Equity Markets – though access to direct financing is improving or expanding, yet it is the banking sector (which is witnessing rising non-performing loans) that is the dominant source of lending and will continue to be so in the foreseeable  future, given the underdeveloped bond and equity markets in China;
• Rates of Return: the rates of return on capital and investment are declining or lowering in China, due to which an increasing number of loans can go sour. An increasing amount of credit is being required to generate less and less growth;
• Debt Servicing Burden: corporates, in particular, are facing rising debt servicing burden, which in turn restricts the amount of money that can be used for productive purposes – that generate employment and growth; 
• Interest Payments: a worrying development in China is that interest payments are taking up more and more of new credit that is issued;
• External Demand: global economic growth is likely to remain lackluster over the medium term (with emerging markets slump likely to continue and developed economies growth likely to be low and uneven without structural reforms and debt reduction), which in turn will continue to dampen demand for Chinese exports and consequently act as a drag on Chinese economic growth; 
• Volatile Source of Funding; the substantial credit expansion in China, rather than relying more on retail deposits, has increasingly been reliant on wealth management products (that offer higher rates), which is risky as it is a volatile source of short-term funding for banks that is used to back much longer-term loans. This can lead to liquidity risks and cause some banks considerable pain, which in turn, as a logical corollary, is bound to dent economic growth;
• Unproductive Use of Debt: corporates are taking out loans and increasingly using cash flows to repay debt or to service outstanding debts or to avoid default/bankruptcy, resulting in less funds being available to finance new investment. The longer this continues, productivity and growth will suffer; 
• Corporate Defaults: the corporate sector is already witnessing high and rising leverage and defaults are likely to rise further amid slowing growth. Rising corporate defaults will increasingly weigh on growth over the next couple of years via its adverse effect on bank balance sheets and availability of credit. Essentially, corporate profitability in China has eroded in the past five years (which undermines the debt-servicing ability of firms) and slowing growth has adversely affected the health of the corporate sector. All this has been reflected in rising non-performing loans of banks. With growth likely to slow down further in the medium-term, bank loans to the corporate sector potentially at risk are bound to rise and corporate profitability will possibly continue to fall. Consequently, debt servicing ability of the corporate sector is likely to be undermined further – adding to balance sheet pressures across the economy;
• Monetary Policy: is likely to become less effective as corporate debt rises, because firms will probably focus on repayment of debt even if interest rates are reduced substantially, rather than borrow for productive purposes that enhance growth;
• Short-Term Stimulus: China’s debt and investment-fueled growth – to bring about short-term economic stabilization – could actually lead to lower growth in the medium term, as it is likely to worsen the long-standing structural imbalances that exist in China.

Factors that should prevent a hard landing of the Chinese economy in the near future

Despite the previously mentioned factors that will probably affect growth in the medium term significantly, several factors are likely to prevent a hard landing of the Chinese economy in the foreseeable future:

• Fiscal and Foreign Exchange Buffers: China has large fiscal (according to the Ministry of Finance, national government debt ratio was 41.5% as of the end of 2015 – which is low by global standards) and foreign exchange buffers (China still has substantial foreign exchange reserves – US$ 3.19 trillion as of May 2016 – according to data from the Chinese central bank. It might be noted that foreign reserves fell by US$27.9 billion in May – the largest monthly drop since February. Earlier, forex reserves had risen by US$7.1 billion in April and US$10.3 billion in March) to prevent a disruptive economic slowdown or a hard landing;
• Debt: most of the Chinese debt is denominated in yuan and consequently China is hardly dependent on financing debt from foreign sources (instead, its financial system is dominated by its banks). According to IMF’s Global Financial Stability Report (April 2016), at the end of 2015, China’s outstanding stock of foreign debt was about US$1.4 trillion i.e. Chinese external debt is low;
• Domestic Savings: China has a substantial savings rate of nearly 50%, which allows banks to have stable funding through retail deposits and wealth management products;
• Household Debt: Household debt as percentage (%) of GDP in China is moderate (according to data from Bank of International Settlements, total credit to households in China was only 39.5% of GDP as of 2015Q4) and household balance sheet are healthy – which should continue to support consumption and help weather an economic downturn. However, households have been increasing their debt since 2007 and it is increasing fairly rapidly, yet the average level of household debt remains moderate. Consequently, there is considerable room for higher consumer spending based on consumer debt, which in turn should positively impact economic growth in the medium-term;
• Consumer Finance: the Chinese central bank wishes to promote consumer finance as it seeks to expand the size of this market, in order to boost household spending to support growth and rebalance the economy in terms of growth being more reliant on consumption, rather than on investment and exports. One should therefore expect lenders to step up consumer financing activities in the near future, which in turn should lead to more credit creation for the consumer segment in the near future and drive consumption at the expense of fixed investment – an imperative to rebalance the Chinese economy;
• Banking Sector: China’s banking sector though facing increasing non-performing loan ratio and inadequate capital adequacy ratio, is in a much healthier state than it was in 1997;
• Growth: there is more scope to catch up on growth in China as it is less developed (China is in the midst of middle-income transition) than developed economies such as Japan;
• Bond Market: there is considerable room for growth and development of the bond market as an alternative source of capital for China’s expanding corporate sector. This in turn should enable banks to gradually lend more to the household sector (which in turn should support consumption and expansion of the services sector) and to small and medium sized firms over the next few years – which in turn will positively impact economic activity and growth;
• Current Account and Short-Term Funding: China does not face the combination of a huge current account deficit (instead, it has a current account surplus) with reliance on short-term foreign funding – which can be a lethal combination for any economy;
• Real Estate: property bubble in China is much less in magnitude than countries such as the US, UK and Spain in 2008. Consequently, any downturn in the property market is unlikely to have as much downside impact on various business sectors and overall economic activity in China, as it did in the US, UK and Spain;
• Devaluation: there is unlikelihood of a significant devaluation of yuan that could result in a massive outflow of capital from China and substantially increase the burden of debt servicing for firms with dollar-denominated debts and lower household real incomes. I expect the yuan to depreciate gradually by 5-7% over the next 12-18 months. Further, whenever the Federal Reserve raises interest rates this year (I do not expect more than two hikes this year) and beyond, it is expected to proceed rather cautiously with reference to further interest rate hikes – which in turn will put less downward pressure on the yuan. Moreover, China’s central bank retains considerable power to influence yuan’s movements against the dollar and it is unlikely to allow any marked devaluation of the yuan for fears of economic and financial instability;
• Consumer and Services Sector: resilience of the consumer sector, as a result of strong income growth, moderate household debt, continued rise of the affluent middle class and creation of many jobs, thanks largely to the private sector, along with an expanding services sector (for a perspective, the services sector now accounts for a larger share of GDP in China than industry – according to (annual) data from NBS, the services sector accounted for 50.5% of Chinese GDP in 2015) should prevent growth from falling rapidly in the medium term.

Having stated the above, the Chinese economy faces some rather daunting challenges that are either preventing growth from being sustainable or pose a risk to financial stability.

Key Challenges

Some of the daunting challenges/risks that are currently confronting the Chinese economy are:

• First, while “supply side reform” is the major theme of economic policy in China in 2016, the key obstacle or challenge to restructuring of the bloated, inefficient and highly indebted state owned enterprises (SOE’s), which are heavily concentrated in industries such as coal, steel etc. and heavy machinery, is the prospect of millions of jobs that could be lost – which could lead to social unrest and impose huge economic costs (China is resisting closing of loss-making SOE’s and privatization of the same);
• Second, according to official sources, China is planning to lay off 1.8 million workers in the coal and steel industry and wants to reducing steel and coal production substantially – to address issues arising from industrial overcapacity and slowing growth and to rebalance the Chinese economy. Such vast retrenchment in the steel and coal sectors could prove rather daunting. This is because these workers would require retraining and re-skilling as many service sector jobs require skills that these workers simply don’t possess;
• Third, letting credit flow more towards privately owned small and medium sized firms, rather than to state owned enterprises (whom banks traditionally lend to), in order to enable the private sector to develop more rapidly, China to grow faster and reduce the significant non-performing loans of the state owned banks in China;
• Fourth, gargantuan overload of debt (particularly very high levels of non-financial corporate debt) and a worsening of credit-to-GDP ratio, which along with rising non-performing loans of banks could pose a risk to financial stability;
• Fifth, meeting the official growth target of 6.5-7% in 2016 and average annual growth rate of 6.5% between 2016-2020, yet adequately reforming SOE’s;
• Sixth, beginning the deleveraging process in earnest and reducing substantial excess capacity in the industrial sectors, yet preventing growth from plunging or slowing down sharply;
• Seventh, tackling the increasing links between commercial and shadow banks, as there are risks of spillover to the larger financial sector. These increasing links pose a systemic risk. Very rapid development of China’s shadow banking system and credit creation since 2010 is a real cause for concern.