Debt Deleveraging: The Chinese Way

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1 PERSPECTIVES Debt Deleveraging: The Chinese Way March 2 Key Insights Monica Defend Head of Global Asset Allocation Research Qinwei Wang, PhD Economist Global Asset Allocation Research Edited by Claudia Bertino Head of Financial Communication China s expansion of credit has been outpacing its economic growth since the Global Financial Crisis. We believe that this is not sustainable, reflecting a deep problem of resource misallocation in China s economy. A large volume of funds has been channeled into unproductive sectors through local government financing vehicles, State Owned Enterprises (SOEs) and property developers, adding to serious overcapacity in certain sectors and unsold properties. China s policymakers seem to be fully aware of the possible risks. They have adopted a gradual approach to addressing these imbalances, by carefully guiding credit growth towards a more sustainable pace while pushing economic reforms ahead. There is considerable debate in the industry around what will be the end game of China s deleveraging. We think China s policymakers are moving in the right direction to avoid dangerous credit risks. However, this process will have key implications not only for China growth, but also in the rest of the world. China s economic growth is likely to weaken further in the years ahead, with slowing credit weighing particularly on investment and heavy industry. That said, we believe that China can still avoid a systematic financial crisis or a hard-landing in its economy, given the state s control over the banking sector and a large part of the economy, relatively low external vulnerabilities and wide range of available policy tools. One major uncertainty is the property sector, in which around 9% of developers are privately owned. While the most difficult part of adjustment for the sector looks to have been accomplished, in our view only successful structural reforms can allow China to ultimately achieve a smooth adjustment. We have observed positive signs over the past year and expect an acceleration of reform implementations to come. How the process unfolds will likely have profound implications for Emerging Markets, with potential winners and losers. What is the True Problem Underneath Headline Numbers? This is a reflection of deeper problems in the economy. Digging deeper, the problems seem to be largely with local governments and SOEs, while households and the private sector look relatively healthy. 1

2 PERSPECTIVES Debt Deleveraging: The Chinese Way March 2 China s problems seem to be largely with local governments and SOEs, while households and the private sector look relatively healthy. Total Credit (to Non-financial Sector, % of GDP) Government Corporate Household Sources: CEIC, OECD, various Chinese Government Departments, Pioneer Investments, as of February th, 2. In the next few pages, we will focus on analyzing the main debt trends with respect to different actors in the Chinese economy. We will assess the progress and the actions taken by Chinese authorities in dealing with the debt issue and avoiding a credit bubble. Household Debt Still Manageable Household borrowing in China seems to have long been depressed, as opposed to being excessive. Consumer credit is still much lower than in other major economies relative to the size of the economy, not to mention that household deposits are around 8% of GDP. In other words, China needs to encourage consumer credit, such as financing through credit cards, for cars and durable products. This process should go hand in hand with the effort to rebalance the economic model toward consumption. Even mortgage borrowing is not worrying (around %), compared with 74% for the US at its 28 peak. Household Consumption Financing (% of GDP, Total for 214) Consumer credit is still much lower than in other major economies relative to the size of the economy, not to mention that household deposits are around 8% of GDP Mortgage Car Others (including credit cards) Sources: CEIC, Pioneer Investments, as of February th, 2 Government Debt: Official vs. Shadow Figures Official figures on China s government debt, around 2% of GDP, appear fairly low. That said, they don t take into account of out-of-budget borrowing by local governments. 2

3 PERSPECTIVES Debt Deleveraging: The Chinese Way March 2 A large part of borrowing by local governments was financed through a shadow banking system and used to fund relatively poor projects. China s local governments have not been allowed to run budget deficits. In practice, however, they had been allowed to finance through local government financing vehicles (LGFVs) to fund their infrastructure projects. Such borrowings have soared since the Global Financial Crisis. Overall government debt, explicit and implicit, is around 6% of GDP. This still looks manageable, compared with other major economies. However, a large part of borrowing by local governments was financed through a shadow banking system and used to fund relatively poor projects, with some money having flown into officials personal accounts. Such borrowings, lacking transparency and accountability, have raised concerns about the health of China s financial system. Local Government Debt (% of GDP) Government bond (issued by central govn., in budget) Others (trust and entrusted loans, and other shadow banking) Corporate bonds (issued by local govn. financing vehicles) 21 H Bank loans The major contributor to the rise of the Credit/GDP ratio has been the corporate sector. In contrast, the private sector overall looks to have been doing relatively well. Sources: CEIC, various Government Departments, Pioneer Investments, as of February th, 2. Corporates: State and Property Sectors are the Real Issue The major contributor to the rise of the Credit/GDP ratio has been the corporate sector. However, the problem is not isolated to the corporate sector. There are major concerns with respect to the state and property sectors. The State Sector Unproductive investments by many SOEs have added to serious overcapacity in certain sectors, such as steel, shipbuilding and solar panel manufacturing, with continued increased reliance on credit to pay back existing debt and to maintain operations. In contrast, the private sector overall looks to have been doing relatively well. In fact, a long-term problem in China has been that private firms face difficulties in accessing credit and as a result have to save for the most part to finance their projects, which has been a major contributor to the country s high savings rate. Indeed, as the following two charts suggest, the debt burden of SOEs has worsened sharply since the financial crisis, while the debt burden of private 3

4 PERSPECTIVES Debt Deleveraging: The Chinese Way March 2 firms has actually eased. This reflects low productivity in the state sector while returns for private firms have held up at relatively high levels. Not all private firms are healthy. Property developers have become much more dependent on borrowing than during the pre-crisis period. Debt (of Asset %, Industrial Firms) Return on Assets (%, Industrial Firms) State-owned firms Privately-owned firms Privately-owned firms State-owned firms Sources: CEIC, Pioneer Investments, as of February th, 2. The Property Sectors Not all private firms are healthy. Property developers have become much more dependent on borrowing than during the pre-crisis period, as their holdings of unsold properties have continued to rise. Real Estate and Construction Sectors (%) , 3, 3, The major concern in the real estate sector is oversupply. However, we believe that worries over a nationwide price bubble have probably been overdone Debt/asset ratio Sources: CEIC, Pioneer Investments, as of February th, 2. Return on total asset The major concern in the real estate sector is oversupply, a form of overcapacity. However, we believe that worries over a nationwide price bubble have probably been overdone. Chinese household income, on average, has been growing at a pace similar to or faster than property prices for most of the last decade. This means affordability has improved for the country as a whole. The situation is uneven though, with serious problems in some smaller cities. 2, 2, 1, 1,, 4

5 PERSPECTIVES Debt Deleveraging: The Chinese Way March 2 The root cause behind China s credit risks is resource misallocation, with funds having been channeled into unproductive sectors. Residential Property Prices Relative to Wages (2 = 1) Sources: CEIC, Pioneer Investments, as of February th, 2. The upshot is that the root cause behind China s credit risks is resource misallocation, with funds having been channeled into unproductive sectors, mainly local government financing vehicles (LGFVs), the state sector and property developers. In contrast, balance sheets for the private sector outside of property, the central government and households have remained relatively healthy. Can China Avoid a Hard-Landing? China s large scale debt build up over such a short period is rare in recent history. This has become a major global macro concern for investors. That said, unlike many others, we have believed that the risk of a systemic crisis in China s economy has remained contained based on three major factors: We continue to think China s financial system is far more resilient than it first appears, with limited risks of contagion. 1. We continue to think China s financial system is far more resilient than it first appears, with limited risks of contagion: Borrowers, such as LGFVs and SOEs, look weak, but they are ultimately backed up by the government. Nearly 7% of all credit (bank loans) remains under control of stateowned banks, which are, in effect, policy arms of the government. The concern regarding the country s shadow banking system has likely been overdone. The key players in the shadow banking system are still China s banks. Trust products are sold through banks; entrusted loans are facilitated by banks; bankers acceptance bills are created and discounted by banks.

6 PERSPECTIVES Debt Deleveraging: The Chinese Way March 2 Outstanding Stock of Credit Bank loans 7% 18% 12% Other credit implicitly backed by banks Credit created outside the banking system (mainly corporate bonds) Sources: CEIC, Pioneer Investments, as of February th, 2. We believe that Beijing still has adequate policy tools to shore up the economy when necessary on both the fiscal and monetary sides. 2. Meanwhile, in our view, China s external vulnerability remains low. China continues to run large current account surpluses almost every month, which means the country is a net saver and does not rely much on global financial markets for financing. China has retained effective capital controls and there is no concern over large capital flows cross the border. China has sufficient FX reserves, more than five times its short-term foreign debt and able to support almost 2 year s imports. These factors allow the People s Bank of China (PBOC) to remain in control of the Renminbi (RMB) exchange rate, although it has reduced its direct intervention in FX markets over the last few quarters. 3. We believe that Beijing still has adequate policy tools to shore up the economy when necessary on both the fiscal and monetary sides. On the monetary side, policymakers can choose a benchmark rate cut and required reserve ratio (RRR) cut in case of serious situations. On a more regular basis, they can use open market operations, lending facilities, re-lending programs and other targeted measures to support the economy. Over the last couple of years, the PBOC has also created new tools for liquidity injections, such as Medium-term Lending Facility (MLF), without relying on Forex (FX) purchases. On the fiscal side, China s central government still has room to fund infrastructure projects in certain areas, although local governments are set to be restricted. Indeed, China is preparing around RMB1trn infrastructure projects in the face of the current economic slowdown. China s credit risks still seem manageable for now, as this is largely a domestic problem and the economy does not rely on foreign borrowing to a significant degree. One major uncertainty is in the property sector, in which around 9% of developers are privately owned. For now though, recent policy support, including easing of purchase controls and a cutting of mortgage rates, appears to be helping to stabilize conditions in the sector, as property sales have held up relatively well over the last couple of months. Although we think growth of property activity is likely to remain low over the coming years compared with double-digits from previous years, any further slowdown is unlikely to be as bad as last year. In other words, the most difficult part has perhaps passed for the sector. Overall, China s credit risks still seem manageable for now, as this is largely a domestic problem and the economy does not rely on foreign borrowing to a 6

7 PERSPECTIVES Debt Deleveraging: The Chinese Way March 2 Policymakers are trying to restrict the channeling of credit towards problematic sectors, while supporting the right areas. significant degree. Ultimately, it will take a redistribution of income among domestic entities to clean up potential bad debts. The level of control afforded the government should make this adjustment much easier and smoother than in other major economies. How to Deleverage The Chinese Way If China s credit risks continued to accumulate, they would ultimately spiral beyond control. Fortunately, Beijing has listed high leveraging risks as its top concern and is taking decisive actions. The process is likely to be painful, but these measures seem to be headed in the right direction, which should allow China to achieve a relatively smooth adjustment. What is policymakers strategy to deal with the continued rise of the Credit/GDP ratio? 1. Policymakers have made efforts to control credit growth and to prevent credit risks from accumulating too rapidly. In particular, they are trying to restrict the channeling of credit towards problematic sectors, while supporting the right areas. In the second half of 213, the PBOC kept monetary conditions relatively tight. This led to a slowdown of credit growth. That said, it also weighed on the economy for both the state and private sectors. Beginning in 214, policymakers have gradually adjusted their stance by increasingly relying on strengthening regulations to limit the flow of credit to the wrong sectors. At the same time, they have eased monetary conditions to support the rest of the economy and implemented targeted measures to support smaller businesses and agriculture. In particular, regulators have strengthened oversight of shadow banking activities and restricted lending to local government financing vehicles. By channeling resources towards more productive sectors, this could maintain GDP growth at a relatively high rate, with less reliance on credit. 2. Meanwhile, China s leaders have shown a strong determination to push structural reforms. The aim of these measures is to improve resource allocation, which targets exactly the root cause for the accumulation of credit risks. By channeling resources towards more productive sectors, this could maintain GDP growth at a relatively high rate, with less reliance on credit. The reform plan announced in the 3rd Plenum of the Party in 213 includes liberalizing financial markets, improving accountability and transparency of fiscal management, and increasing the role of markets. We have observed continued efforts in all of these areas. For example, China has raised the cap on bank deposit rates, allowed the formation of private banks, passed the plan for fiscal reforms and cleaning up existing local government debts, and further opened up the services sector. There are strong signs that further reform measures will come this year. 7

8 PERSPECTIVES Debt Deleveraging: The Chinese Way March 2 China's Credit Growth vs GDP Growth (% y/y) Without transformation of China s inefficient financial system, the traditional way of monetary easing would benefit the state sector and developers most, which could add to credit risks over the mediumand long-term Credit growth (latest = Jan.) GDP growth (nominal, latest = Q4) Sources: CEIC, Pioneer Investments, as of February th, Why are policymakers cautious about aggressive monetary easing in the face of an economic slowdown? Despite continued weakness in the economy, Chinese policymakers have been cautious about monetary easing. Policymakers have repeated their stance that they do not want to ease monetary policy aggressively or broadly. This makes sense given the concern over still rising leveraging risks. Without transformation of China s inefficient financial system, the traditional way of monetary easing would benefit the state sector and developers most, which could add to credit risks over the medium- and long-term. A recent lesson in this regard was provided in 212; at that time, aggressive easing did little to boost growth but left China with a surging Credit/GDP ratio and a rebound in property investment. This means that policymakers will probably choose benchmark rate and RRR cuts only under occasionally circumstances of economic distress. More often, they are likely to use open market operations, lending facilities, re-lending programs and other targeted measures. Ultimately, they will probably try to avoid a sustained rebound in credit growth. Chinese policymakers have been cautious about monetary easing. They seem to prefer a gradual path (manageable slowdown) rather than a quick adjustment. While slower credit growth is likely to weigh on investment and therefore economic growth, policymakers seem to prefer a gradual path (manageable slowdown) rather than a quick adjustment, as they have strong fears of possible social instability. China s leaders have repeatedly emphasized in all major official statements the need to safeguard the bottom line in preventing systemic and regional financial risks". They fear that a financial crisis and economic hard-landing could lead to high unemployment, low income growth and social instability, thus threatening the Party s ruling position. Implications The deleveraging process in China is likely to be a major macro scenario over the next few years, which will probably have profound implications for both China s own economy and others. 8

9 PERSPECTIVES Debt Deleveraging: The Chinese Way March 2 The balance faced by policymakers is between guiding credit growth towards a more sustainable pace (closer to GDP growth) while also avoiding a hardlanding of the economy. 1. China s economy: further managed slowdown with structural adjustment We would like to see a further slowdown of credit growth over the next couple of years. This will likely continue to weigh on investment demand and therefore economic growth, but consumption and services should hold up relatively well with reform measures supporting household income growth and the services sector. 2. Policy stance: 1) Monetary policy: Policymakers seem to be taking a slightly easier monetary policy stance than last year, with plenty of tools to choose from, including continued targeted measures and occasional rate and RRR cuts when necessary. While seeking to control the flow of credit towards overcapacity sectors and local governments, they are also seeking more ways to support Small Medium Enterprises. This is acting to moderate slowdown of overall credit growth. 2) Fiscal policy: The government has been preparing a group of infrastructure projects to offset downward pressures from strengthened oversight of local government financing and spending. The budget deficit is likely to be gradually increased to replace out-of-budget borrowing by local governments. However, the overall fiscal stance is likely to be gradually tightened. The balance faced by policymakers is between guiding credit growth towards a more sustainable pace (closer to GDP growth) while also avoiding a hardlanding of the economy. One important bottom line objective is to keep labor markets healthy. 3. Ultimately, we believe that only reforms can help China achieve a smooth adjustment, and we remain cautiously positive on this front. The deleveraging process implies a structural shift of China s economy from investment towards consumption. With increasing signs of strong determination and ability on the part of China s leaders to push reform, we expect reform implementation to accelerate. In particular, we would like to see further moves on financial liberalization, fiscal reforms, land reforms, and hukou reforms for migrant workers. 4. For other EMs: The deleveraging process implies a structural shift of China s economy from investment towards consumption. This means that metal commodity producers, such as Latin America, South Africa and Australia will probably continue to suffer, while other economies may benefit from a more sustainable and consumption-driven economy. 9

10 Ang Zam Chl SA Sau Kuw Mal Per Vie Ven Twn Kor Idn UAE Tha Bra Ukr Rus Phl Arg Ind Col Nig PERSPECTIVES Debt Deleveraging: The Chinese Way March 2 Exports to China (% of Own GDP) 24% We believe that China, among EMs, is better positioned in terms of structural reforms and the political will to complete them Metals Energy Agriculture Sources: UN COMTRADE statistics, Pioneer Investments, as of 211. In conclusion, we believe that the risks of a hard landing due to a credit bubble are low compared to the opportunities that a transition toward a more mature economy may bring to investors. Moreover, we believe that China, among EMs, is better positioned in terms of structural reforms and the political will to complete them. The investment implication of this view from an asset allocation perspective is that we continue to favor China equities. Important Information Unless otherwise stated, all information contained in this document is from Pioneer Investments and is as of February, 2. The views expressed regarding market and economic trends are those of the author and not necessarily Pioneer Investments, and are subject to change at any time. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading on behalf of any Pioneer Investment product. There is no guarantee that market forecasts discussed will be realized or that these trends will continue. These views are subject to change at any time based on market and other conditions and there can be no assurances that countries, markets or sectors will perform as expected. Investments involve certain risks, including political and currency risks. Investment return and principal value may go down as well as up and could result in the loss of all capital invested. This material does not constitute an offer to buy or a solicitation to sell any units of any investment fund or any service. Pioneer Investments is a trading name of the Pioneer Global Asset Management S.p.A. group of companies. Date of First Use: 4 March 2. Follow us on: _2