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China: when will the hangover of the debt binge set in?

Economic Quarterly Report

  • In macroeconomic terms, the Chinese economy seems to have stabilised. The sizeable capital flight seen earlier this year appears to have waned, and economic growth has recovered to some extent, partly due to higher investment
  • The government’s accommodative policy, however, is leading to potentially risky credit and housing market bubbles
  • While the debt burden continues to increase, profitability of state-owned enterprises is declining and this is putting ever more pressure on financial stability
  • Without substantial reforms, China is running the risk of ending up in a Japan-like scenario: a slowly stagnating economy due to declining credit growth for healthy companies and increasing inefficiencies 

A cautious recovery …

Figure 1: Capital flight is waning, as well as downward pressure on FX reserves
Figure 1: Capital flight is waning, as well as downward pressure on FX reservesSource: Macrobond, Capital Economics, Rabobank

The Chinese economy seems to have stabilised. The strong capital flight seen earlier this year appears to be under control, even though foreign investors are still bearish on China (see Figure 1). The main reason the pressure is off now, is that Chinese companies have ceased to reduce foreign liabilities, something that earlier caused large capital outflows. Consequently, there is less necessity for heavy intervention by the People’s Bank of China (PBoC) in order to support the Chinese currency (RMB). This has also resulted in a stabilisation of the country’s foreign currency reserves.

Investment is rising, private consumption is weak

Economic growth has picked up again after two sharp downturns last year (see Figure 2). The Rabobank China Activity Indicator (CAI) shows real economic growth in March of 4.7%. This is much lower than officially is reported (6.7% for Q1), but is much better than the 3.5% that our CAI showed in December 2015. The recovery is mainly due to credit-fuelled investment growth, mostly in infrastructure and real estate. Investment growth in manufacturing and construction also appears to have stabilised after years of stagnation. On the downside, so far we do not see many signs of the much-needed transition from an investment-driven industrial economy towards more consumption-driven one. Both the growth of private consumption, as well as retail sales are on a downward growth trajectory.

Figure 2: Economic growth according to the Rabobank China Activity Indicator (CAI)
Figure 2: Economic growth according to the Rabobank China Activity Indicator (CAI)Source: Macrobond, Rabobank
Figure 3: Depreciation of RMB against currencies of main trading partners
Figure 3: Depreciation of RMB against currencies of main trading partnersSource: Macrobond, Rabobank

Trade is recovering from the slumps

After a very weak year, exports are beginning to pick up again, partly due to the depreciation of the RMB against currencies of China’s major trading partners (see Figure 3). In value terms, trade was still in negative territory in April, but in volume terms and when adjusting for seasonal effects, both imports as well as exports are growing again, by 5% and 4% respectively.

Meanwhile, markets are anticipation of the PBoC’s response to the Fed’s rate hike, which is expected for June or July. Since China has an implicit peg against the US dollar (USD), its competitive position will clearly come under pressure if the dollar further appreciates. If China decides to abandon the peg, however, this could lead to major turbulence on financial markets, as we have experienced last September (Figure 3).

… influenced by heavy government intervention

Figure 4: Home sales rise 30% in the first quarter
Figure 4: Home sales rise 30% in the first quarterSource: Macrobond, Rabobank

In order to avoid a further slowdown of economic growth, the Chinese government has taken various measures to stimulate the economy. First, the PBoC has reduced the required reserve ratio (RRR) for banks by 50bp. This supported credit growth which gave a boost to the economy. Total lending, including loans to local governments, increased by a staggering 15% in the first quarter of 2016 (y-o-y). The government also eased conditions for house purchases at the beginning of the year, apart from the five major tier-1 cities.[1] Combined with relaxing credit conditions, this policy has given the housing market a significant boost (see Figure 4). Sales increased by 30% y-o-y in the first quarter of this year, and house prices in the major cities are currently rising rapidly as well.

[1] The down payment for a home has been reduced from 30% to 25% (with the option for local governments to reduce this rate to 20%) and country transaction taxes have also been cut.

The housing market and debt bubbles

The question is whether the current government policy is creating new credit and asset bubbles. As a result of tighter capital restrictions and the low interest environment, investors and developers are looking for new domestic investment opportunities. After the stock market bubble burst in the summer of 2015, the housing market in the major cities is a predictable new target. The mass flight of investors into real estate implies that at least part of the house price surge in the major cities is speculative in nature (see also The Economist). However, the government does not yet appear to be planning to introduce additional macro-prudential measures to limit the rapid increase in real estate values in the major cities, as this would likely weigh on business and consumer sentiment nationwide.

Apart from the rapidly accelerating house prices, the accumulation of debt in China is another cause for concern. Although China’s debt mainly consists of domestic loans, the pace of debt accumulation is worrying: total debt as a percentage of GDP has risen from 150% to 255% in just seven years (figure 5) and the level of debt substantially exceeds that of other emerging market.

The credit-driven investment model has helped the Chinese economy to mitigate the negative effects of the Great Recession by raising growth. However, additional lending to business no longer seems to be having any effect (see Erken and Kalf, 2016). This is partly explained by the fact that a large proportion of new lending is used to roll-over the existing large debt of state-owned enterprises (SOEs). Meanwhile, net profitability of these SOE’s is under pressure, which makes it more difficult for these firms to service their debt (see Figure 6). Already several smaller SOE’s have been defaulting on their interest payments. Payment problems are mainly concentrated in more traditional industrial sectors that have a lot of overcapacity, such as coal and steel. Going forward, these sectors will have to be consolidated but his will entails losses for the banking sector.

Figure 5: Increase in debt from 150% to 255% over 7 years
Figure 5: Increase in debt from 150% to 255% over 7 yearsSource: Macrobond, Rabobank
Figure 6: Net profit of state-owned enterprises under pressure
Figure 6: Net profit of state-owned enterprises under pressureSource: Macrobond, Rabobank. Trend line is calculated with an HP filter (lambda=1000).

If the government restricts access to credit and existing loans can no longer be rolled over, many SOEs will run the risk of bankruptcy and mass layoffs of millions of Chinese workers will be unavoidable. This will undeniably cause social unrest to flare up; something the Chinese government wishes to avoid at all costs. So, when it comes to deleveraging the economy, the hands of the government are practically tied. Interestingly, an extensive article was published in the People’s Daily on the May 9th, where an ‘authoritative’ person addressed the excessive debt accumulation and warns that the economic recovery will probably be L-shaped rather than V- or U-shaped (see Bloomberg).

Japan 2.0

It is highly unlikely that China’s debt and housing market problems will be spiralling out of control and send a shockwave throughout the global economy. Therefore, we do not expect a Lehman-style scenario for China. If more SOEs run into trouble or there is a sharp correction on the housing market in tier-1 cities, the government will probably step up to mitigate the negative effects. And, even if the government is unwilling or unable to bailout firms directly, monetary financing is always an option as the debt is almost entirely domestically financed. In the past, the government has shown little appetite for painful reforms and has not been ready to accept mass layoffs or bankruptcies that would be the result of reducing overcapacity at non-viable SOEs. This ‘sticking-plaster’ policy, however, came at the expense of the efficiency of the Chinese economy in recent years (see Erken and Blaauw, 2016). Keeping inefficient and unprofitable zombie firms alive (whether by means of monetary financing or not) will continue to distort the supply for credit, as they absorb part of the financing that otherwise would have been allocated to productive healthy. As zombie-dominated sectors show overall lower productivity, employment creation and profitability (Caballero et al., 2006), the lack of determination on the part of China’s policy makers will weigh on growth in the coming years.

Hugo Erken
RaboResearch Netherlands, Economics and Sustainability Rabobank KEO
+31 6 2223 1650
Jurriaan Kalf
RaboResearch Netherlands, Economics and Sustainability Rabobank KEO

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