For some, China represents a positive scenario of structural reforms returning the country to its position as the engine of world growth. Not only do we think this is unlikely, we actually believe China poses a systemic risk of historic proportions.
It is now clear that China is not smoothly passing its growth baton from exports and investment to the service sector. Official GDP data still show growth, but this has decelerated significantly despite numerous interest rate cuts and massive fiscal support.
The reason for such weakness is debt. It is hard to exaggerate the magnitude of the Chinese debt bubble. According to the Band for International Settlements, debt to GDP has increased by around 100 per cent since 2008, which compares with about 40 per cent in the US leading up to the subprime meltdown, 60 per cent in Japan prior to its collapse in 1997 and is even more than the credit booms of Greece, Portugal, Spain and Italy in the run up to the euro crisis. The only similar credit bubble in recent history was that in Thailand before the Asia crisis. And if an economy the size of China’s goes through what Thailand went through in 1997, the world will be a very ugly place indeed.
Chinese debt is concentrated in the corporate sector, but this distinction is blurred given the use of state owned enterprises and local authority lending vehicles by the Chinese government during the investment binge. According to Autonomous Research estimates, corporate sector debt will rise to above eight times income in 2016, double its level in 2008. There are many zombie companies that simply have to borrow just to service their current debts. Gavekal Dragonomics estimates that 28 per cent of Shanghai Composite companies are loss-making when subsidies are stripped out. And debt is still growing rapidly, with credit growth running at twice the rate of nominal GDP expansion.
One positive aspect is that the vast majority of debt is funded domestically, so China’s external vulnerability is nothing like Thailand’s in 1997. However, this still means Chinese savers are on the hook. As with all debt bubbles, there has been a great deal of financial engineering to hide the debt and who guarantees it. In China, banks have created vast off-balance sheet structures named Wealth Management Products (WMP) that are stuffed full of bank loans, funded by short-maturity deposits. The US and Europe had their own off-balance sheet vehicles in 2008 – SIVs and conduits – which subsequently blew up when the mortgage debt bubble collapsed. Autonomous Research estimates that by the end of this year Chinese WMPs will be more than double the size of the $1.7tn SIV/conduit market in 2008.
Even more worrying has been the rise of peer-to-peer (P2P) lending, which has all the hallmarks of a Ponzi scheme. In January, authorities closed down P2P lender Ezubao, with 900,000 investors facing losses of $7.6bn between them. Total P2P loans quadrupled in 2015 to around $150bn and the Chinese regulator thinks that about a third of P2P lenders are problematic.
Estimating the amount of debt that needs to be written off by China is not an exact science. It boils down to how much excess capacity has been built with little chance of making an economic return. Julien Garran at MacroStrategy estimates there has been around $8tn of excess fixed capital formation in China since 2008, which, assuming that 60 per cent turn into non-performing loans and a 40 per cent recovery rate, suggests losses of $3tn. This is about 30 per cent of Chinese GDP. Autonomous Research gets to a similarly large number by looking at losses realised by other countries following their own credit bubbles. This far outstrips the loss-absorbing capacity of the financial system, and would therefore require significant state support to resolve.
The key to a crisis is domestic confidence. Chinese policymakers are trying very hard to avoid the worst. Instead, they are attempting to take the Japanese route of delaying the final judgement day. However, this is a double-edged sword. Volatility remains subdued for now, but the future crisis is getting larger.
This year has already witnessed a number of Chinese policies that help paper over the cracks. The housing market has been in focus, with purchase restrictions being lifted leading to a rapid increase in house prices across a handful of major cities. However, there is still a huge nationwide housing inventory backlog that needs to be worked through. It now seems as though restrictions are being tightened once again to try to avoid this localised housing bubble.
There have also been headlines of fiscal loosening, with Beijing lifting the official central budget deficit to 3 per cent of GDP for 2016. However, the true government deficit is already around 10 per cent, if we include local authority budgets, funded via a surging government bond market. It will be difficult to accelerate this already breakneck speed.
Not recognising non-performing loans is also part of a broader policy of ‘extend and pretend’. However, not crystallising losses does not make their impact go away. Even if the Chinese debt mountain does not collapse overnight, it will continue to weigh on domestic economic activity and inflation.
This Japanese extend and pretend policy does not solve the structural problems in China, it simply delays and worsens the final resolution.