6 December be today. The stimulus measures to rescue the economy after the 2008 crisis saw

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1 6 December 2013 China s local l dbt debt problem calm before the storm, or storm in a teacup? Grace Tam Vice President Global Market Strategist JP J.P. MorganFunds Ian Hui Market Analyst Global Market Strategy Team J.P. Morgan Funds Overview The level of China s debt has long been a topic of concern, with worries that a surge in financing and lending activity has made the country susceptible to a banking crisis, as a quickly increasing level of debt is seen by many as a precursor to a credit bubble and crash of the financial system. Nevertheless, we do not expect an imminent financial crisis in the Mainland, given the country s high saving rates, bank-centric financial system, strong fiscal revenues and robust economic growth. The latest local debt au udit indicates Beijing s strong determination to resolve the problems. However, investors should monitor the situation closely, as it could become a real storm if the government fails to slow the pace of rising debt levels. Credit growth, not credit levels is the concern During the financial crisis in 2008, the Chinese government s response was a large stimulus plan, with investment fueled by easy credit. The credit boom since that period has generated worries not only with the general public, but also with policymakers. Based on both official data from its last audit in 2010 and estimated data from the IMF, local government debt is calculated to be around 3 of GDP for Between 2009 and 2010, this percentage almost doubled from 17% of GDP to around the levels of what it is estimated to be today. The stimulus measures to rescue the economy after the 2008 crisis saw many state-owned enterprises (SOEs) and local governments take advantage of loose monetary policy to heavily increase their borrowing. Some of this was done through off-balance sheet financing using local government financing vehicles (LGFVs), which are commercial window companies set up by local administrations to fund infrastructure projects. Local governments had limited sources of revenue as they could not issue bonds, and so used these LGFVs to quickly roll out investment proje ects and dfinance capital expenditures (capex). With some of these investments not being productive, credit quality of these entities has been a concern ever since. This proliferation in LGFVs has caused outstanding local government debt to balloon to the total of around a third of GDP that we see today. Compared with other economies, this ratio does not seem to be out of control, but the pace of increase may be another matter. The results of a nationwide government debt audit are expected to be announced soon, and will hopefully bring further clarity to government debt levels in China.

2 Chart 1: China debt in comparison Debt as % share of GDP, Government Household Corporate China Germany US Korea UK Japan Local government investment vehicles loans are included in the corporate sector, data are as of 2011, China data is a BCA estimate as of Source: BCA, OECD When considering China s total debt levels, using the broad measure of credit, or total social financing (TSF) released by the People s Bank of China (PBOC), varying estimates for the total amount of debt outstanding currently hover around 20. The central bank s total social financing concept covers most of the credit in the system and accounts for both bank and non-bank lending. Using the TSF figures, JPMorgan estimates total social debt to be 194% of GDP in 2012, compared to 145% of GDP in 2008, an almost 50 percentage point increase in the last 5 years. Banks sharply increased lending related to the stimulus package after the global financial crisis, while more recently banks offbalance sheet credit and other shadow banking credit channels have expanded rapidly. Chart 2: China s debt/gdp ratio has increased quickly after Total Social Financing (volume) 10 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 While there is considerable scope for argument over what may be considered the danger level for the debt-to-gdp ratio, and that China s own ratio is not the highest compared to other countries, faster credit growth combined with slower GDP growth does bring into question whether debt servicing costs the ability of borrowers to repay their loans will be readily met in the future without causing further drag on China s GDP growth. Related to this debt issue is transparency. The financial situation of local governments and businesses in China is not always clear and reports may be considered unreliable by skeptical investors. China s non-performing-loan (NPL) ratio for commercial banking is not particularly high at around 1. as of end of But there are worries that it may be underestimated due to attempts to hide any credit problems and that in China it is largely up to the banks judgment when classifying NPLs. Growth of shadow banking adds to issues Adding to uncertainty over debt levels is the credit being issued by non-bank lenders, popularly known as shadow banking activity. The definition of shadow banking taken from the Financial Stability Board is typically credit intermediation involving entities and activities outside the regular banking system. Shadow banking credit mainly includes off-balance sheet credit of banks, wealth management products and credit from other financial institutions such as trusts. It is less regulated, less transparent, with poorer risk control and is extended mostly to the sectors that faced credit constraints in the formal sector, including local government platforms, developers, commodity traders and companies that otherwise have cash flow issues. The TSF figure from the PBOC includes most of the shadow banking in China, with the exception of some items such as underground or informal lending. Various calculations differ when counting the amount of shadow banking as a percentage of GDP in China, but most estimates place it around 5-7 of GDP. Compared with other countries, this figure is relatively low. But once again, the rapid increase in growth these last few years has sparked concern, especially with shadow banking s lack of transparency. Source: PBOC, J.P. Morgan 2

3 Chart 3: Shadow banking in comparison Shadow banking % share of GDP, US Euro area UK Japan Hong Kong 260 China figure is J.P. Morgan estimate in Source: Financial Stability Board (FSB), J.P. Morgan Singapore China Global The Chinese government has taken some steps to restrain shadow banking growth, as even though a cross-country comparison suggests the size is relatively l small, they are uneasy with the aforementioned already high credit growth rate. Nevertheless, shadow banking does serve some useful purposes, namely building up alternative financing channels and promoting interest rate liberalization by providing market-based deposit and lending rates. No imminent financial crisis Compared with many Developed Markets, China s total debt level of around 20 of GDP is not particularly high, but it is much higher than many Emerging Markets. The high and rising debt levels in China have raised global investors concerns that the debt burden would lead to a financial crisis in the Mainland. Nevertheless, we do not anticipate an immediate crisis in China due to the following four reasons: (1) China has the highest national saving rate in the world (51% of GDP in 2012) Massive domestic savings can certainly help finance the debt. This also explains why China could maintain a high investment share of GDP ratio (49% in 2012), which has been mainly funded by credit expansion and the retained earnings of the SOEs. Chart 4: China s savings rate still one of the highest Gross national savings as % of share GDP, China Korea Germany Japan United States Source: IMF 24 Many of the financial crises in Emerging Markets in the past were either due to a sudden sharp outflow of foreign capital or a panicked exit from the local currency by domestic depositors. For China, the largely closed capital account helps to keep its domestic savings at home, as well as preventing large short-term capital outflows. Very limited foreign exposure to Chinese banks as well as the domestic equity and bond markets also limits the extent of foreign outflows United Kingdom Furthermore, with the lack of variety of investment vehicles in the Mainland, local people have not much choice but to save plenty of money in the banks. Chinese banks total loan-to-deposit ratio is currently below 7, much lower than it was 10 years ago (above 75%) despite the credit boom after the Global Financial Crisis. (2) China s financial system is dominated by banks A bank-centric financial system rather than one that depends heavily on equity financing helps to prevent the domestic economy suffering too much from China s highly volatile equity markets, as bank lending (mainly funded by deposits) rather than stock market performance holds the key for the costs of capital for corporates. Even though the shadow banking system has developed rapidly in recent years, it is still relatively small and much less complicated than the non-bank financial system of the developed world, with negligible high risk derivatives and collateralized debt obligations. 3

4 Chart 5: Share of Other FI and hence shadow banking still relatively small Share of overall financial system (%) Other FI Insurance/pension Commercial banks Source: FSB, Emerging Advisors Group Public FI Central bank DM Other EM China Despite the small liquidity crunch that happened in June this year and some bad news about the wealth management products, earnings results of Chinese banks continue to be robust, with a strong capital base, rising profits and very low NPL ratios. Both loans and deposits are still registering double-digit annual growth. Also, compared with global banks, Chinese banks score highly in terms of their profitability, liquidity, asset quality and loss absorbing capacity in global surveys. In fact, the Chinese banks have significantly increased the provision coverage ratio of NPLs in recent years. The provision coverage ratio has risen almost 8 times, from 4 in 2007 to over 30 at present, implying that banks are well-prepared for a worst case scenario. (3) Local debt is more a fiscal burden than financial burden As the local debt problem is mainly concentrated in LGFVs on infrastructure development, it is hard to believe Beijing would allow a series of defaults or let banks shoulder all the losses that could jeopardize the financial system. Therefore, local government borrowings would ultimately become a fiscal responsibility that the central government has sufficient fiscal ability to absorb, although we would not expect to see any explicit guarantees by Chinese officials due to concerns over moral hazard. Apart from tax revenue, fiscal transfer and land sales, the Chinese government also owns considerable assets that can be used to bail out local governments when necessary. Nevertheless, working out a resolution plan for failing LGFVs is a very challenging process due to conflicts of interests between central and local governments. Furthermore, central government officials may allow some small financial institutions to fail, but not the bigger stateowned depository banks in China, which means that in practice they carry an implicit guarantee by the central government. (4) China has strong GDP growth Robust economic growth is important to debt sustainability. Even though China has now entered an era of slower growth, its nominal GDP is still showing growth of around 9-1, ahead of the debt service cost, which is around 6-7% at present. Overall economic activity as indicated by the high frequency macro data also shows that the Chinese economy is still largely stable. The problem is already well-known Global media has already had very wide coverage of the issues. Credit rating agencies such as Fitch and Moody s have downgraded China s sovereign debt ratings and the country s sovereign debt outlook, respectively, as a result of rising leverage and poor transparency on local government finances. More importantly, tl China s policymakers are well alerted on the issue and have been taking precautionary measures in recent years. For example, they have tightened credit in the property market, imposed stricter scrutiny on shadow banking activities and more restrictions on local government borrowing. The latest PBoC Monetary Policy Report published on 5 November also mentioned that the economy may see a decline in leverage the first time the central bank has talked about deleveraging in an official document. This implies a tightening bias in monetary policy going forward. All this suggests that local debt issues are unlikely to provide systemic shock to policymakers, or investors, that could lead to a financial crisis or market panic in the short term. 4

5 Possible solutions Apart from assessing the outstanding amount of local debt, we believe one of the main purposes of the latest round of LGFV audits is to figure out a resolution to the various problems. Here are some of the strategies the Chinese authorities are likely to employ in the near future: 1) To continue to slow down overall credit expansion (slower economic growth allows slower credit activity), especially shadow banking activities 2) To establish a mechanism to allow local governments to fund their long-term projects and alleviate their cash flow issues; for example, to develop a local government bond market 3) To restructure some existing debts or even create local government-owned asset management companies to take over the bad debts, while some smaller LGFVs would be allowed to go bankrupt and enter financial supervision 4) Banks to roll over many of the outstanding LGFV debts and shoulder some of the debt burden; hence, their NPLs would rise and earnings growth would slow 5) To continue to roll out structural reforms to encourage private investment, allow industrial consolidation (so the stronger companies would enjoy better profit margins) and improve productivity growth Investment implications Although the high absolute debt level per se is not a good indic cator of looming financial stress and we do not expect to see an imminent risk of systemic stress in the financial system, the rapid pace of increase in debt is more worrisome, as it is not sustainable over the longer term. The storm in the teacup could eventually become a real storm, if the government fails to slow credit expansion in the near future. Investors should keep an eye on the monthly bank loan and total social financing data, as well as any new policy measures and the implementation of the structural reforms announced after the third plenum in November, to gauge how Chinese officials are going to tackle the problems. 5

6 Past performance is not a guarantee of future results. Any forecast contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. Opinions, estimates, forecasts and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without further notice. The information provided herein should not be assumed to be accurate or complete. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategiess described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not interpreted as recommendations or investment, product, accounting, legal or tax advice. J.P. Morgan Chase & Co. group assumes no responsibility or liability whatsoever to any person in respect of such matters. The views expressed are those of J.P. Morgan Asset Management. These views do not necessarily reflect the opinions of any other firm or other division of the JPMorgan Chase & Co. group. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. This communication is issued by the following entities: in Hong Kong by JF Asset Management Limited, it JPMorgan Funds (Asia) Limited it or JPMorgan Asset Management Real Assets (Asia) Limited, all of which are regulated by the Securities and Futures Commission; in India by JPMorgan Asset Management India Private Limited which is regulated by the Securities & Exchange Board of India; in Singapore by JPMorgan Asset Management (Singapore) Limited or JPMorgan Asset Management Real Assets (Singapore) Pte. Ltd., both are regulated by the Monetary Authority of Singapore; in Taiwan by JPMorgan Asset Management (Taiwan) Limited or JPMorgan Funds (Taiwan) Limited, both are regulated by the Financial Supervisory Commission; in Japan by JPMorgan Asset Management (Japan) Limited which is a member of the Investment Trusts Association, Japan, the Japan Investment Advisers Association and the Japan Securities Dealers Association, and is regulated by the Financial Services Agency (registration number Kanto Local Finance Bureau (Financial Instruments Firm) No. 330 ); in Korea by JPMorgan Asset Management (Korea) Company Limited which is regulated by the Financial Services Commission (without insurance by Korea Deposit Insurance Corporation) and in Australia to wholesale clients only as defined in section 761A and 761G of the Corporations Act 2001 (Cth) by JPMorgan Asset Management (Australia) Limited (ABN ) (AFSL ) which is regulated by the Australian Securities and Investments Commission. This communication is for intended recipients only and may only be forwarded or presented to other persons in compliance with local law and regulations which shall be the intended recipients sole responsibility. Investment involves risks. The value of investments and the income from them may fall as well as rise and investors may not get back the full or any of the amount invested. Recipient of this communication should make their own investigation or evaluation or seek independent advice prior to making any investment. It shall be the recipient s sole responsibility to verify his / her eligibility and to co mply with all requirements under applicable legal and regulatory regimes in receiving this communication and in making any investment JPMorgan Chase & Co. 6

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