China

Whilst President Xi of China and President Trump of the US go toe to toe on trade, the financial landscape in China is undergoing fundamental structural change.

Reports about increasing levels of debt in China have been worrying economy watchers.  Burgeoning debt within the corporate sector has been under increasing scrutiny. It heralds vulnerabilities associated with borrowing. The corporate sector is especially susceptible during slowdowns.

As a command economy it is not surprising that the corporate sector has been used by the Chinese authorities as a conduit for stimulating growth, particularly in relation to infrastructure. This approach involves taking on more debt. In China the corporate sector is dominated by State Owned Enterprises (SOE’s). SOE’s are able to accommodate large scale capital investment programmes, funded by borrowing, and being centrally directed, banks’ lending to them are not inclined to dictate what represents too much borrowing. Today, the country’s corporate debt to GDP ratio (illustrated below) currently sits at a staggering 160%, with debt levels rising sharply since December 2008.

Chinese Corporate Debt to GDP Ratio and GDP YoY growth

Source Bloomberg, data as of November 2018

Thankfully, memories of the financial crisis are still strong in the minds of central banks, including the Peoples Bank of China (PBoC), which is the Chinese central bank. As shown by our chart, the financial crisis, which began in 2007, caused China’s YoY GDP to fall from 13.9% to 7.1% in 2008, a dramatic event. Growth subsequently recovered but China’s rate of growth has been slowing. This is a function of the economy maturing from ‘developing’ to ‘developed’ status.

Reflecting on slowing growth and a new plan, the Chinese authorities are now guiding policy on lending differently. They want to make sure elevated debt levels do not trigger the next systemic economic crisis. Their key aim right now is not the level and amount of debt held by SOE’s, but tackling debt which has grown uncontrollably through clever financial engineering. This lies elsewhere and has emerged through what is known as the shadow banking sector. Shadow banking is when financial intermediaries operate without regulatory oversight, unlike ordinary banks which must follow set criteria. The details behind shadow banking are complex to explain but the result is not difficult to understand. By using complex arrangements, a loan of 100RMB from a financial intermediary operating in the shadows can create a 400RMB liability trail. Multiplying by a factor of 4, excess levels of debt within an economy can take hold quickly.

As a result, the PBoC has decided to take strong action against this type of lending. New and updated regulatory rules are now focusing on:

• restricting banks’ off balance-sheet activity
• tightening rules on liquidity and credit risk management
• raising the standards of corporate bond issuance

The Chinese authorities know that consequences arise from amassing debt. They do not want to repeat the painful events of the 2008 financial crisis hence they are now acting with due care. If left unregulated, the shadow sector represents a ticking time bomb for the Chinese economy. The precondition for this to happen is typically slower growth. This causes default rates to increase and it can be the beginning of a downward spiral. However, the PBoC is not looking to cut the overall debt to GDP ratio just yet. They understand the role that debt can play within economic expansion and the main issue right now is where the debt is situated.

In terms of high debt levels more generally across the economy, and debt within SOE’s, there are reasons to be more relaxed:

• China’s debt is backed by high levels of savings in both the corporate and household sectors
• Debt held by the SOE’s is effectively subject to a de facto government guarantee
• China’s foreign exchange reserves stand at $3trn and they operate a large trade surplus of $234bn (which is a key reason underlying the trade spat with the US)

We have pointed out on several occasions that China is on a path of transition. It is looking to change from a manufacturing led economy to one with a greater services component. Debt, used properly, has the power to drive growth and bring about change. However, if left to expand uncontrollably, and without oversight by the central authorities, it also has the power explode. Being careful now will be like letting air out of a balloon before it pops.