China’s debt self-contained but rising at a worrying pace says Legal & General IM

6th June 2013


China’s debt problem is self contained with the country not reliant on foreign savers, but the speed debt is rising at a worrying pace says Legal & General Investment Management’s emerging market strategist Brian Coulton in a note issued this week.

Coulton says debt ratios have risen sharply and investment returns are declining though is partly reflected by a surge in quasi-fiscal spending. “A high savings rate limits the risk of a crisis but growth challenges are rising. Reforms, rebalancing and restraint in the use of stimulus policies will be needed to ensure sustainable growth at 7½%.”

He says China’s current account surplus has fallen sharply since its peak of 10% in 2007, though it is still positive at nearly 3% GDP in the first quarter of 2013, illustrating that domestic savings still outweigh national investment needs. Corporate sector funding needs are more than outweighed by the surplus savings.

The external balance sheet shows China is a net external creditor to the tune of 42% of GDP. “The risk of a withdrawal of foreign funding as a catalyst for a sharp slowdown – a typical pattern in past emerging market crises – is therefore substantially reduced in China,” the note adds.

However Coulton notes that China’s economy is piling up debts with a combination of rising credit and falling GDP growth reviving concerns about excessive leverage in the economy and the ratio of credit to GDP has risen sharply.

He adds: “High debt in individual sectors raises the vulnerability of the economy to interest rate and other shocks, and increases financial stability risks.”

LGIM estimates the stock of gross debt in the real economy to be roughly 190% of GDP.

“This is high by emerging market standards, though not particularly alarming in the context of China’s high saving and growth rates. By means of comparison, a recent BIS study showed a debt ratio of 306% on average for major advanced economies, with much higher household (90%) and government debt ratios (104%) than China. However, the pace of increase is more worrying – a rise of nearly 60% of GDP in just four years. This is equivalent to the total increase in US non-financial debt from 2002 to the peak in 2009/2010 and raises concerns about the misallocation of capital and financial stability.”

A significant proportion of this increase was accounted for by the corporate and the ‘unidentified’ sectors says Coulton.

The note adds: “These two components include quasi-fiscal debts accumulated by local government financing vehicles (LGFV) as they funded infrastructure projects related to China’s stimulus programme. Data transparency in this area is very poor but a fiscal audit pegged this at CNY10.7trn (22% of GDP) in 2010. A recent Fitch estimate suggested it had grown further to CNY13trn (25% of GDP) by the end of 2012. It is likely that LGFV debts were modest prior to 2008.”

Coulton says there are worries about the deteriorating standards of allocation of capital

“Over the longer sweep of history, high investment has delivered rapid growth in the capital stock and this, in turn, has delivered high GDP growth. Nevertheless, there is little doubt that investment performance has deteriorated more recently. Since2008 the investment share of GDP has risen at the same time as GDP growth has fallen, pointing to declining marginal productivity of capital.”

“Average capital productivity has also fallen at an annual average rate of 4.5%. Profit growth was weak in 2012 and the share of profits in GDP fell. Firm-level data also shows a decline in corporate return on equity, particularly in the state-owned enterprise (SOE) sector.

“These trends may partly reflect the particularly rapid growth in infrastructure investment during the stimulus – where the pay-off in terms of GDP growth is only seen after a long time. But the sheer pace with which credit and investment expanded is likely to have contributed to poor investment decisions. A rise in credit to GDP on the scale seen in China in the last five years as often pre-dates a financial crisis or period of macroeconomic stress,” he says.

The note points out non-performing loans in the banking sector have remained very low to date at less than 1%, although there are doubts as to whether this accurately reflects the true level of payment stress. “The risk is that elevated debt and debt servicing levels will result in rising defaults as nominal GDP growth and corporate revenues slow.”

The note says that a particular concern has been the rapid rise in ‘off balance sheet’ lending in the form of what are known as Wealth Management Products (WMPs).

“These products offer savers higher interest rates than the regulatory maximum on bank deposits and allow banks to grow assets without breaching loan quotas. The stock of WMPs has grown spectacularly from under 6% of GDP in 2009 to 15% of GDP today and a large share of the funds has been invested in the rapidly growing corporate bond market.

“While motivated by regulatory arbitrage, the majority of WMPs issued by banks offer only a small premium over deposit rates and are backed by similar assets to banks’ on balance sheet exposures. However, the WMP market also includes around CHY2trn (3.7% of GDP) of much higher risk products issued by Trust Companies to high net worth individuals. One fear is that failures in Trust Company WMPs – which have already occurred on occasion – spark a loss of confidence in these products more widely, impacting the banks.”

However once again, with high levels of liquidity, Coulton says it is difficult to see this becoming a full blown financial crisis.

Finally the note says China’s policymakers need to focus on the three Rs: reform, rebalancing and restraint. “Reforms to encourage a reacceleration in the share of the private sector in the economy would boost productivity growth. SOE’s are the heaviest and most inefficient users of credit and reducing their influence would allow a slowdown in credit growth without damaging the real economy. Restructuring the SOEs will be challenging politically, but deregulation to allow faster growth of new private sector activity could also contribute significantly.

“Rebalancing the demand side drivers of growth away from investment towards less credit-intensive consumer spending would also help. The government is planning tax changes in the service sector and has prioritised the consumer sector. Consumer spending has risen slightly as a share of GDP in the last two years. LGIM’s projections of GDP growth potential factor in a decline in the investment ratio over the medium term but, to date, the ratio has only tracked sideways since its sharp jump up to 45% of GDP after 2008. Finally, policy makers will need to show restraint in their use of credit and investment-focused macro policy stimulus. This is where trade-offs are arguably most acute in the near term, as softer growth and subdued inflation brings calls for short-term stimulus. The authorities will need to tread a delicate path between avoiding too sharp a slowdown in demand and the further build up of leverage. The trade-off between stabilisation policies and medium-term growth performance has become sharper. China’s transition to moderately slower growth will not be an easy ride.”

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