The Chinese credit boom could lead to stress in the domestic banking sector and an extended periods of below-trend economic growth.
Chinese economic growth has stabilised in the recent quarters, posting 6.8%yoy at the end of last year. Both manufacturing and services PMI have been above the expansion threshold of 50 since the mid-2016. In addition, industrial production and fixed asset investments for February beat expectations, rising 6.3%yoy and 8.9%yoy from 6.0%yoy and 8.3%yoy in January respectively.
However, the ability of China to pursue financial liberalisation, improve the management of government finances and State Owned Enterprises’ (SOE) activities continues to pose risk to the long-term outlook. The 7-year decline in GDP growth trend reflects the slow progress in containing vulnerabilities and advancing structural reforms. The long-term economic outlook highly depends on the degree of commitment the government will put into structural reforms as the country continues to converge toward more developed economies.
Less monetary easing
With the FOMC tightening monetary policy in the US, the Chinese authorities will need more flexibility in conducting economic policy. The end of the quantitative easing followed by the beginning of the tightening cycle in the US led to strong downward pressures of the Renminbi and large capital outflows. As a result, the People’s Bank of China (PBOC) sold US$1tn of its currency reserves since 2014 to slow down the depreciation of the Renminbi and Chinese regulators applied stricter capital controls. However, the explicit and implicit costs associated with these policies – the forced divestiture of the currency reserves and the rise of risk aversion due to stricter capital control respectively – were simply too high. In March, Chinese officials announced further liberalisation of the Renmimbi exchange rate.
We believe that there will be more currency liberalisation and financial liberalisation over the medium term. China launched a pilot programme, earlier this year, aimed at granting more flexibility for offshore funding for local companies where the proceeds of offshore funding can be remitted to the domestic market. Over time, these capital inflows would partly offset the capital outflows from local companies paying back offshore debts and ultimately stabilise the capital account.
We expect the PBOC will gradually tighten monetary policy in order to slowdown the credit boom, reduce the capital outflows, and alleviate downward pressures on the Renmimbi.
In the short term, we expect higher currency volatility and bond risk contingent on the next PBOC’s policy move.
Credit overhang problem
In the aftermath of the financial crisis, China’s economic growth has relied on credit and investment fostered by an accommodative monetary policy. As a result, China’s total debt surged, from 145% of GDP in 2007 to almost 260% of GDP at the end of 2016, increasing the stress on the domestic banking system and declining investment efficiency. China’s debt continues to grow at a fast pace (13%yoy in 2016), although at a declining rate. In the meantime, non-performing loans ratio reached 1.8 in 2016, up from 1 in 2012.
The corporate sector has been the largest contributor to the explosive trend on the credit market. The corporate debt reached 160% of GDP in 2016, up from 100% of GDP in 2008.
Chinese banks provide the largest part of the financing of the economy. Banks’ credits and loans represent 70% of the total social financing (TSF). The non-bank lending, so-called shadow banking activities1, represents 16% of TSF, while capital markets on the other hand – the equity and bond financing – accounts for the smallest share of the TSF (14%).
However, the bulk of corporate liabilities are concentrated in State Owned Enterprises (SOEs) which have limited global financial exposure and are implicitly backed by the central government. According to the IMF, China’s total government debt (including local government debt) remain relatively low at 60.4% of GDP in 2016, suggesting the Chinese government has significant fiscal buffers to absorb potential losses. In addition, the international exposure of the Chinese public debt is limited as China’s external debt remains relatively small (12.7%) compared to GDP.
Foreign exposure and contagion risks
We used the foreign banks’ claims on Chinese counterparties (banks, private and public sectors) as a proxy for assessing the financial exposure of foreign investors to Chinese credit.
According to BIS data, the demand for foreign credit from China has risen significantly from the mid-2000s to an all-time peak at the end of 2014, driven by the rise of offshore funding led by record-low interest rates in developed economies. After 2014, the demand for foreign credit declined sharply (-US$155bn) as the Fed started to taper its asset purchase programmes, before stabilising in 2016. Half of the growth in foreign claims on China over the past decade has come from the rise of foreign credit to Chinese banks. The other half has taken the form of foreign credit to Chinese non-bank private sector.
Despite the decline, foreign banks’ exposure to China remains significant in nominal terms. Foreign banks’ claims on counterparties resident in China account for a total of US$658bn at the end of 2016, close to banks’ exposure to Italy.
However, in relative terms, the offshore Chinese credit market is small (6% of GDP) compared to other emerging countries (14% of GDP in average) and developed economies (41% of GDP in average).
Among all reporting countries, banks from the United Kingdom appear to be the most exposed to the Chinese credit market with 23% of total foreign claims, followed by the US, Europe and Japan with 13%, 12% and 10% respectively.
Overall, China remains relatively financially closed compared to peers. We see low risk of potential international spillovers from the Chinese domestic credit market stress given the small amount of Chinese liabilities held by foreign banks.
Morgane Delledonne – Associate Director, Fixed Income Strategist – ETF Securities