Many investors are focused on the outlook for trade talks between the US and China, fearing an all-out trade war which would negatively impact global equity markets. But investors are underestimating the mounting problems caused by the rapid expansion of credit in China in recent years. Only radical solutions now remain to resolve China’s credit bubble.
The fear of a US/China trade war has been grabbing all the headlines – and spooking investors – in recent months. A fragile truce has been reached but the effects of the dispute are being felt in markets throughout the world
A trade war is certainly a concern. But we feel markets are under-pricing other – potentially bigger – systemic risks to the Chinese economy: namely, the rapid and worrying expansion of credit in recent years.
Growth has been faltering in China, falling from over 14% annually pre the financial crisis to 6% % now, a major contraction for the world’s second largest economy. The Chinese authorities have yet to respond by turning the credit taps back on stimulating the economy with increased borrowings. The problem is that the further this credit expansion extends the less effective this strategy becomes.
In 2008, the return on credit, which measures how effective new credit is at stimulating growth, was running at around 0.75. So, each CNY 1 of credit generated CNY 0.75 of nominal gross domestic product (GDP). Since 2014, this ratio has averaged 0.25.
More worrying still are the rising tail risks. However you look at it, the massive expansion in credit in China in recent years should be triggering alarm bells. Key measures which track the growth in credit in China tell us that this rate of expansion is not only unsustainable but will lead to a significant hike in non-performing loans. At some point this will have a major knock on negative impact on China’s fixed income and equity markets.
Unsustainable credit growth
Take the stock of credit to GDP, which measures the level of credit in relation to the size of the economy. When both on and off-balance sheet credit is included, some estimate that in China it has grown by over 150% since the financial crisis from a base of almost 150% (see Figure 1). In our view, this puts China’s banking sector firmly in the crisis category.
Figure 1: China total credit to GDP
Source: PBOC, China Trustee Assoc., HKMA, BIS, CEIC, Wind, company data, Autonomous Research, Bloomberg, Columbia Threadneedle estimates.
By comparison, in the US from 2000 to 2008 in the run up to the financial crisis, the measure grew by 81%. Indeed, every time credit has expanded by over 30 percentage points over a five-year period from a base of over 100%, it has ended badly.
The credit-to-GDP gap, a measure favoured by the Bank for International Settlements, which tracks credit-to-GDP in relation to its long run trend, is also cause for concern. In China in recent years this gap has been running at over 20%. Looking at banking sector crises over the last 50 years, a gap of this magnitude is a very good indicator of a banking crisis to come.
We believe investors in China should be preparing for a wave of defaults. Official Chinese data points to non-performing loans of just 2%. But history tells us that when credit has been expanding at the rate it has been in China, non-performing loans are more likely running at around 20%.
So where are these non-performing loans? The answer is in three places: local government lending which is often used to finance infrastructure projects; banks’ off-balance sheet exposure (in particular the hugely popular wealth management and asset management products which are used to take lending off banks’ loan books); and China’s smaller banks which have grown much faster than their larger rivals in recent years. (Problems there are already coming home to roost as three institutions, with combined assets totalling $400bn, have been rescued this year by the authorities.)
The numbers are big. As a whole, the Chinese banking sector has expanded around 3.5 times to $36 trillion since 2008. The off-balance-sheet loan book in China alone is estimated at around $4.5 trillion, bigger than the total loan book of the four biggest US banks
Implications for equity and bond markets
The good news is that, with the exception of the corporate sector, foreign currency borrowing in China is low. So, a rerun of the 1997 Asian crisis in China, where high dollar borrowing was the trigger, is not a concern.
However, there are around $45 trillion of banking assets in China when off-balance-sheet assets are included. With China holding an estimated $3 trillion in foreign currency reserves, it would not take much in the way of capital withdrawals for these reserves to be quickly eroded.
In the event of a need to shore up the banks, the Chinese authorities will be forced to take a more radical step. This could see the government recapitalising the banking sector, a move we calculate could dramatically increase the country’s official debt-to-GDP levels from current levels of around 48% to over 70%. This would still be in line with many western governments. But it would be no small a step.
Five years ago, we felt the sharp credit expansion in China could have been managed with minimal disruption to markets. Not any more.
China could become the first nation to be able to absorb such a sharp expansion in credit without experiencing problems, either by skilful deleveraging and lower growth, devaluing the currency, or more likely via an expensive recapitalisation of the banking sector. However, the risk of an abrupt and painful bursting of the Chinese credit bubble, with serious ramifications for global growth due to its importance in the global economy, cannot be ruled out.
Either way, investors can expect even more dramatic movements in equity and bond markets than have been caused by current US/China trade war fears.
Author: Paul Smillie Senior Investment Analystat Columbia Threadneedle Investments. To find out more contact your financial adviser
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