Emerging Markets Weekly Economic Briefing

214 Emerging Markets Emerging Markets Weekly Economic Briefing Why rapid debt growth in China might be a risk Is China facing an imminent financial crisis? The rapid expansion of credit in China since the 28/9 financial crisis rings warning bells. Fast-growing corporate debt; the increasing role of shadow banking; a slowdown in the property market; rising non-performing loans and a slower future growth all give rise to concern. If a crisis is on the cards whether explosive or slow-burn what would be the regional and global implications? We will investigate these issues in detail in a series of articles over the next few weeks. In this introductory article we look at the facts behind China s current debt build-up. China is experiencing a credit boom Credit booms can be beneficial, and need not end in calamity. They can help emerging economies to build up capital, providing a framework for wealth creation. As China s experience over the past few decades has shown, rapid credit growth has helped to drive up investment and consumption, resulting in real GDP growth of over 1% a year until 21. China: Credit growth % y/y 4 3 3 2 2 1 1 Bank Loans Total Social Financing 26 28 21 2 214 Source: Oxford Economics/Haver Analytics but there is a limit to sustainable growth There is a limit to sustainable credit growth, though, beyond which the costs of servicing the debt outweigh the benefits from higher productivity. This can result in a toxic combination of high debt and slowing growth. Too much income goes to debt maintenance and too little to consumption, hence growth slows. Unless something gives, debt as a share of GDP rises over time, producing a vicious circle that pushes growth down further, making it difficult to escape the rising debt burden. Economies have several ways of reining in unsustainable credit growth, including a chaotic financial crisis (the US experience) or a long period of debt deflation (as in Japan). All eventually result in the required rebalancing, but are painful and damaging for growth. Managing a slowdown will be hard Identifying the limit to sustainable credit growth is hard, but it is unlikely that China has reached it yet. The real challenge for the authorities is therefore to manage a slowdown in credit growth and push on with rebalancing the economy before the limit is reached and a crisis does the job instead. There are some encouraging signs on this front. Recent steps towards tighter banking regulation and some regulation of the shadow banking sector are moves in the right direction. The current administration also seems to be making progress towards financial liberalisation by widening the renminbi trading band in March and introducing the Shanghai Pilot Free Trade Zone at the end of 213. Nothing has yet been done to address the problem of existing bad debts, however, which are likely to be substantially underreported. 1

214 Emerging Markets Total debt is now 244% of GDP And Chinese debt is still rising fast. We estimate that total debt has increased from 176% of GDP in 27 to 244% 1 at the end of last year. A large part of this increase is in corporate debt, as state owned enterprises (SOEs), which still dominate the corporate sector, were encouraged to borrow to invest heavily in the aftermath of the global financial crisis. This huge fiscal and monetary stimulus limited the downturn in China, but resulted in a large build-up of debt. mostly to the corporate sector China: Outstanding debt % GDP 2 2 1 1 General Government Local Government Nonfinancial Corporations Financial Sector Households 27 21 213 Source : Oxford Economics/Haver Analytics As the chart shows, most lending is to corporates, and this is where most of the risk lies. We do not know how much corporate debt is accounted for by SOEs, but it is likely to be a substantial majority. China: Gross interest expenses as % of profits % of industrial enterprises' profits 4 3 2 1 State owned and holding enterprises 21 23 2 27 29 211 213 Private enterprises Total 1 The total may be slightly lower, depending on how LGFVs are treated For now, SOEs can easily cover interest repayments from reported profits. But lower GDP growth forecasts and overcapacity mean this may not always be the case. There are several thousand SOEs, most left to their own devices, but a core of 113 are directly administered and regarded as essential to the economy. The authorities would be expected to bail them out if they face difficulties. Hence lending to them is effectively lending to the government. Some commentators have argued that the authorities have not allowed private companies to make long-term investments or borrowing, so they carry a low risk of default. Private sector property developers are likely to be highly exposed to a correction in the property market, so the risk is not negligible. but government debt is underestimated At around 36% of GDP, China s total government debt is low in comparison with both developed economies and many emerging ones. This is partly because some government borrowing is reported as corporate debt. While local governments are not allowed to borrow cash, they need additional funding to cover shortfalls between their income and expenditure. The accumulated gap between fiscal revenues and expenditure since 1998 amounts to RMB 29.4tn. Most has been funded by selling land-use rights totalling RMB 19.8tn. The remaining RMB 9.6tn is raised through local government financing vehicles (LGFV). LGFV debt amounted to RMB 9.7tn or 16.9% of GDP in mid-213. Household debt is low Household debt is also low in China, at just 34% of GDP. This is very different from the US, where households ramped up their borrowing before the financial crisis to invest in financial assets and property. Although property is also seen as an investment in China, and prices in the main cities are facing a correction after rapid increases, households are far less exposed. First-time buyers are required to provide a down-payment of 3%; other buyers need a 6% deposit (some investors hold several properties as a store of wealth, without renting them out). For mortgage purposes, houses are valued at just 8% of their market value. Mortgage debt is estimated to be 27% of disposable income at the end of last year, but as the chart shows, household loan repayments are a very small proportion of average incomes. (What we cannot see from these data is whether the debt is concentrated in relatively few, highly geared households, which would raise the risks.) 2

214 Emerging Markets China: Gross interest expenses as % of income % of household disposable income 3. 3. 2. 2. 1. 1... 21 23 2 27 29 211 US: Household debt service ratio Debt service payments as % of disposable personal income 14. 13.. 11. 1. 9. 199 1993 1996 1999 22 2 28 211 / Federal Reserve Board A different picture from the US? Although it is impossible to put a hard number on it, the evidence suggests that a substantial proportion of Chinese borrowing has been used to invest in infrastructure and industrial production, via SOEs. It is either government borrowing, or implicitly guaranteed by the state. Relatively little, at least compared with recent US experience, has been used to invest in financial assets. Exposure to the housing sector is harder to gauge, and potentially more of a risk, as we highlighted in a Research Briefing on 19 June. With much of China s debt still effectively backed by the state, therefore, default risks are relatively low. The risk that China s rapid credit growth is fuelling investment in unproductive assets is considerably higher. Slowing credit growth before it becomes unsustainable is crucial, but very hard to do in practice. Subsequent articles will investigate how the position could unwind and what that might mean for China and the world economy. 3

214 Emerging Markets Latest data Recent Data Releases Previous month Latest Comment China - Official PMI (Jun) - HSBC Manuf. PMI (Jun) - HSBC Services PMI (Jun).8 49.4.7 1..7 3.1 The HSBC manufacturing PMI showed that new orders rose to a 1-month high, a trend that is likely to continue to be supported by infrastructure investment over the coming months. Both PMIs also showed stronger export orders. The services sector picked up. India - HSBC Manuf. PMI 1.4 (May) 1. (Jun) Manufacturing output and orders continued to pick up but the recovery will be gradual. Brazil - HSBC Manuf. PMI 48.8 (May) 48.7 (Jun) Manufacturing contracted at the sharpest pace in almost a year, contributing to our GDP downgrade. We expect the economy to grow by 1.% this year, down from 1.4% last month. Russia - HSBC Manuf. PMI 48.9 (May) 49.1 (Jun) The PMI continues to suggest weakness. Mexico Exports (May, s.adj) Imports (May, s.adj) - Trade balance (m total) 2.1% m/m.9% y/y 2.1% m/m 3.3% y/y $.2bn (Apr) 1.3% m/m 7.1% y/y 1.4% m/m.3% y/y $.7bn (May) Exports of petroleum products and cars both rose by more than 3% m/m in May, boosting the trade surplus. Imports rose by more than 1% m/m in March, April and May, suggesting domestic activity is beginning to build stronger momentum. Korea CPI (Jun) - Core CPI (Jun) - Exports (US$, Jun) - Trade balance (m total) - HSBC Manuf. PMI 1.7% y/y 2.2% y/y -.9% y/y $4.7bn (May) 49. (May) 1.7% y/y 2.1% y/y 2.% y/y $4.bn (Jun) 48.4 (Jun) Trade growth has been subdued so far this year, with average monthly exports in Q2 up only 3.% y/y. The won has rallied this year and alongside weak export prices and slowing demand from China, this makes for a challenging external backdrop. As a result, manufacturing conditions have deteriorated and the PMI worsened in June against the broader regional trend of improvement. Taiwan HSBC Manuf. PMI 2.4 (May) 4. (Jun) New domestic and export orders rose strongly. Turkey Exports (May, s.adj) Imports (May, s.adj) - Trade balance (m total) -7.3% m/m 7.3% y/y 1.% m/m -9.1% y/y -$93.1bn (Apr).3% m/m 3.2% y/y 2.9% m/m -2.9% y/y -$92.1bn (May) Exports have been patchy so far this year, particularly trade in intermediate goods. But the gradual EU recovery, which takes around 4% of Turkey s merchandise exports, and the expected improvement in the tourism sector, should boost external demand. Thailand Private Spending Private Investment (May) - Current Account (m tot) -.8% y/y (Apr) -4.8% y/y (s.adj) $8.3bn (Apr) -.3% y/y (May, s.adj) -2.9% y/y $9.bn (May) Domestic activity remains very weak, affected by the political turmoil, but May data suggest it is beginning to stabilise. Strong net exports, albeit mostly due to weak imports, have boosted the current account balance this year. South Africa Exports (May) Imports (May) - Trade balance (m total) -11.1% y/y (US$) -7.% y/y -$17.4bn (Apr) -8.1% y/y -3.7% y/y -$17.6bn (May) Commodity prices, especially metals, remain weak and exports have also been disrupted by strikes in the platinum sector. The trade deficit has widened this year. 4

214 Emerging Markets Events Monetary policy meetings in past week Key rate (now) Outcome Comment Jul 2 nd Poland 2.% (Reference rate) Unchanged The National Bank of Poland kept the interest rate unchanged as expected but dropped its commitment to keeping rates on hold to the end of Q3 214. At the same time the central bank governor said a cut in September was unlikely, despite the risk of deflation. We expect rates to remain on hold into next year. For further information contact Sarah Fowler (sfowler@oxfordeconomics.com)

214 Emerging Markets Asia China: Manufacturing PMI = expansion / contraction line 6 Official PMI India: HSBC Manufacturing PMI = expansion/contraction breakeven point 6 6 4 HSBC PMI (including June 'flash') 4 4 3 2 26 27 28 29 21 211 2 213 214 Source: China Federation of Logistics and Purchasing / Markit 4 2 26 27 28 29 21 211 2 213 214 Source: Markit Korea: Exports US$bn (seasonally adjusted) 4 4 3 3 2 2 1 1 2 22 24 26 28 21 2 214 Source: Korea Customs Service / Oxford Economics Emerging Asia: Trade balance US$ bn 36 3 China 24 18 "Rest of Asia" 6-6 - India -18 month moving average -24 1997 1999 21 23 2 27 29 211 213 Thailand: Consumer spending indicator 2=1 (seasonally adjusted) 16 1 14 13 11 1 9 2 22 24 26 28 21 2 214 Source: Bank of Thailand Thailand: Private investment indicator 2=1 (seasonally adjusted) 26 24 22 2 18 16 14 1 8 2 22 24 26 28 21 2 214 Source: Bank of Thailand 6

214 Emerging Markets Asia Emerging Asia: Bank lending % year 4 Singapore: Residential property prices Index (Q4 1998=1, quarterly averages) 22 3 Indonesia Singapore 2 2 18 16 1 14 Thailand Malaysia -1 2 22 24 26 28 21 2 214 / IMF 1 2 22 24 26 28 21 2 214 Source: Singapore Urban Redevelopment Authority Emergers: Exchange rates v US$ Index (Dec 3, 21 = 1) 11 11 China 1 1 Korea 9 9 Indonesia 8 appreciation 8 India 7 7 6 Jan 11 Jul 11 Jan Jul Jan 13 Jul 13 Jan 14 Emergers: Exchange rates v US$ Index (Dec 3, 21 = 1) 11 18 appreciation Malaysia Philippines 16 Singapore 14 1 98 96 94 Thailand 92 9 Jan 11 Jul 11 Jan Jul Jan 13 Jul 13 Jan 14 Asia: 1-year government bond yields % 1 9 India 8 7 India: Manufacturing & electricity output % year (3 month average) 2 2 Manufacturing 1 6 4 3 2 Thailand Korea 1 - Electricity 1 Jan 7 Jan 8 Jan 9 Jan 1 Jan 11 Jan Jan 13 Jan 14-1 26 27 28 29 21 211 2 213 214 Source: Oxford Economics 7

214 Emerging Markets Latin America Brazil: Industrial output 2=1 (seasonally adjusted) 11 Mexican GDP & US non-oil import volumes % year % year 1 3 1 1 9 9 8 8 9 6 3-3 -6 US non-oil import volumes (RHS) Mexican monthly GDP proxy (LHS) 28 21 14 7-7 -14 7-9 -21 7 1997 1999 21 23 2 27 29 211 213-1997 1999 21 23 2 27 29 211 213-28 Argentina: GDP proxy & industrial output % year (3 month moving average) 2 Latin America: Trade balance US$ bn Brazil 1 GDP proxy 4 1 - Industrial output -1-1 -2 1997 1999 21 23 2 27 29 211 213 3 2 Argentina 1 Chile -1 Mexico month total -2 1997 1999 21 23 2 27 29 211 213 Latin America: Short-term interest rates % 28 24 Brazil 2 Emergers: Exchange rates v US$ Index (Dec 3,21 = 1) 11 Mexico Chile 1 9 16 8 Brazil Colombia Mexico 7 8 6 Argentina 4 Chile depreciation 2 22 24 26 28 21 2 214 4 Jan 11 Jul 11 Jan Jul Jan 13 Jul 13 Jan 14 8

214 Emerging Markets Emerging Europe Central & Eastern Europe: Retail sales % year 2 Poland 1 Russia 1 Czech - Hungary -1 3 month moving average -1 1999 21 23 2 27 29 211 213 Central & Eastern Europe: Retail sales % year 3 Bulgaria Romania 2 1 Lithuania -1 Estonia -2 3 month moving average Latvia -3 23 2 27 29 211 213 Central & East. Europe: Industrial confidence % balance (unweighted averages of EC measure) 2 Lithuania, Latvia, Estonia, Romania and Bulgaria 1 Central & East. Europe: Consumer confidence % balance (unweighted averages) -1 Lithuania, Latvia, Estonia, Romania and Bulgaria -2-1 -2-3 Czech, Slovak, Poland and Hungary -3-4 Czech, Slovak, Poland and Hungary -4 1998 2 22 24 26 28 21 2 214-21 23 2 27 29 211 213 CEE: Government bond yields %, 1-year bonds 13 11 Hungary 1 9 8 7 6 Poland 4 3 Czech 2 1 Jan 7 Jan 8 Jan 9 Jan 1 Jan 11 Jan Jan 13 Jan 14 Source: Reuters / Haver Analytics Central & Eastern Europe: Interest rates % 24 2 Poland 16 Hungary Romania 8 4 Czech 2 22 24 26 28 21 2 214 9

214 Emerging Markets Rest of World Turkey: Merchandise trade US$bn (seasonally adjusted) 24 22 Imports 2 18 16 14 1 8 Exports 6 4 2 26 27 28 29 21 211 2 213 214 Turkey: Interest rates and inflation % 24 21 18 1 9 6 3 Average bank lending rate 1-week interbank rate "Core" inflation 26 27 28 29 21 211 2 213 214 / Oxford Economics South Africa: PMI = expansion / contraction line 6 6 4 4 3 3 2 22 24 26 28 21 2 214 Emergers: Exchange rates Index (Dec 3, 21 = 1) 1 1 9 9 Turkey (v Euro) 8 8 7 7 S. Africa (v US$) 6 6 depreciation Jan 11 Jul 11 Jan Jul Jan 13 Jul 13 Jan 14 Emerging Markets: Exports US$bn (seasonally adjusted) 24 21 18 1 9 6 3 US non-oil imports Exports of 11 leading emergers (ex China & Russia) China exports 2 22 24 26 28 21 2 214 / Oxford Economics World: Commodity prices 27=1 (rebased) 2 18 16 14 1 8 6 4 CRB raw industrial materials CRB foodstuffs 2 2 22 24 26 28 21 2 214 Oil Copper 1

214 Emerging Markets Industrial Production Percentage changes on a year earlier unless otherwise stated China Brazil Korea India Mexico Russia Turkey Taiwan Poland 213 May 9.2 3.3-1.8-2. -1.3 -..2-1.1.3 Jun 8.9. -.3-1.8-1. 1.7 4.8 1.3 2.7 Jul 9.7 1.2 -.2 2.6 -.9.8 4.1. 3.8 Aug 1.4.4 3.3.4 -.1 -.2 1.6 -.1 4.3 Sep 1.2 2.6 -.2 2.7-1.4 1.3 6.2 -.8 3.9 Oct 1.3.4 1.2-1.2.3 1. 2.1. 4. Nov 1. 1.9 -.6-1.3-1. 2.8 4.7.4 7.4 Dec 9.7-2.8 1.1.1 -.3.4 6.9 4.8 4.7 214 Jan 8.6-1.4 1.1 1.1.9 -.2 6. 1.2 6.3 Feb 8.6 1.1 -.1-1.8. 2.1 4.1 4..6 Mar 8.8-1.1 2.8 -..3 1.4 4. 3..8 Apr 8.7-2.4 2.4 3.4 2. 2.4 4.6..1 May 8.8-2.6 -.7 - - 2.8 -.9 2.7 Consumer prices Percentage changes on a year earlier unless otherwise stated China Brazil Korea India Mexico Russia Turkey Taiwan Poland 213 Jun 2.7 6.7 1.2 9.9 4.1 6.9 8.3.6.2 Jul 2.7 6.3 1.6 9.6 3. 6. 8.9.1 1.1 Aug 2.6 6.1 1. 9. 3. 6. 8.2 -.8 1.1 Sep 3.1.9 1. 9.8 3.4 6.1 7.9.8 1. Oct 3.2.8.9 1.2 3.4 6.3 7.7.6.8 Nov 3..8 1.2 11.2 3.6 6. 7.3.7.6 Dec 2..9 1.1 9.9 4. 6. 7.4.3.7 214 Jan 2..6 1.1 8.8 4. 6.1 7.8.8. Feb 2..7 1. 8. 4.2 6.2 7.9..7 Mar 2.4 6.2 1.3 8.3 3.8 6.9 8.4 1.6.7 Apr 1.8 6.3 1. 8.6 3. 7.3 9.4 1.7.3 May 2. 6.4 1.7 8.3 3. 7.6 9.7 1.6.2 Jun - - 1.7 - - - 9.2 - - 11

214 Emerging Markets Exports (US dollars) Percentage changes on a year earlier unless otherwise stated China Brazil Korea India Mexico Russia Turkey Taiwan Poland 213 Jun -3.1 9.2-1. -3.8 4.8 2. -3.2 8.7 11. Jul.1 -.9 2.6 11.8 3.8 6.2-1.7 1.6 14.2 Aug 7.2-4.3 7.6 13.9.7 3.4-9.1 3.6 1.4 Sep -.3 4.3-1.7.9 4.4 4.4.9-7. 13.2 Oct.6 4.9 7.2 14.3 4. -6.6 -.3.7 9.2 Nov.7 1.9.2 3.6 2.1 3.4 2.1 3.4 7.8 Dec 4.1.6 6.9 3.7 1.2 2.7 4.9 1.2 1.1 214 Jan 1.6.4 -.2 4. 2.7 2.1 7.9 -.4 13.4 Feb -18.1 2. 1.4 -.1 4.4 -.9.6 7.9 8. Mar -6.6-8.8.1-4.8 1.6.8.9 1.9 18.2 Apr.9-4.4 9. 9.6.9 6.7 7.3 6.2 13.4 May 7. -4.9 -.9.4 7.1-3.2 1.4 - Jun - -3.2 2. - - - - - - Imports (US dollars) Percentage changes on a year earlier unless otherwise stated China Brazil Korea India Mexico Russia Turkey Taiwan Poland 213 Jun -.7 1. -3. -1.6 4.8 4.7 7.2 6.6 3.3 Jul 1.9 2.2 3.4 -.3 6.2 1.9.6-7.7 9.7 Aug 7.1.4 1.2 -.4 3.8 -.3.9-1.3 7.2 Sep 7.4 8.1-3. -17.9 2.8 4.9 -.6 -.7 8.2 Oct 7.6 14.6.1-13.4 -.2-4.6.6-2.9 1.1 Nov.3-7. -.6-16. -2.4-2.6 6.3 -..9 Dec 8. 3.9 3. -14.8-1.1 2.. 1. 4. 214 Jan 1..4-1.1-18.9 3.2-3.4 2.6-1.2 9.4 Feb 1. 7.3 3.9-17.9 1.6-9.3 -.6 4.9 9. Mar -11.4-8.6 3.6-3.4 1.7-3.3-3.1 7.4 9.8 Apr.8-11.1. -.3 3.3-7. -9.1.8 11.8 May -1.6-4.8.3-11.4.3 - -2.9-2.3 - Jun - -3.8 4. - - - - - -