China’s Credit Concerns To Constrain Structural Growth

In our June 13, 2013 Global Macro Newsletter (please email us for a copy) and July 31, 2013 commentary (“Our Revised 12-Month Outlook for Major Asset Classes“), we asserted that China will experience a lower structural real growth rate of 5% to 8% over the next five years. The era of consistently double-digit growth rates is over. This is not surprising, for many obvious reasons:

  • Recent growth in China has been highly dependent on an unprecedented burst of credit growth beginning in 2007. Simply put: The “efficiency ratio” of each RMB of credit growth–i.e. the amount of credit to drive a unit of GDP growth–is near a record low. According to official records, an increasing amount of credit is being spent on existing assets as opposed to new capital formation, while less credit-intensive areas of growth, such as exports, have slowed. At the same time, Chinese policymakers are curtailing both formal and shadow banking financing, which does not bode well for credit–nor GDP growth–for at least the next couple of years;
  • Chinese population growth has sunk to a new low of 0.47%, ranking 156th in the world. More important, China’s “demographic dividend” ended a couple of years ago. The Chinese labor force is now growing at a slower rate than that of her retirees. By 2020, China’s dependency ratio (the retiree-to-labor-force ratio) will rise above that of the United States. Overall productivity growth will shrink, and the risk of the Chinese populace “getting old before getting rich” is very real;
  • China’s GDP last year was US$8.2 trillion–just over 50% the size of the U.S. economy. The World Bank projects China to hit her growth target of 7.5% this year, i.e. economic activity in China will hit a whopping $8.8 trillion at the end of this year. The sheer size of the Chinese economy–accompanied by economic maturity along the coast–means China is starting to hit a wall (excuse the pun) in terms of export and capex growth. In fact, Chinese policymakers are now much more concerned about reducing environmental pollution and income inequality than meeting their GDP growth targets;
  • The Energy Information Administration (EIA) projects China to surpass the U.S. as the world’s biggest crude oil importer by October of this year. Chinese oil imports–currently at 6 million barrels/day–is expected to hit 7 million barrels/day by summer 2014. Meanwhile, U.S. oil imports–at 7 million barrels a day–is expected to decline to just 5 million barrels/day by the end of 2014, due to increased domestic oil production, as well as declining gasoline demand. China’s increasing dependency on foreign oil will adversely affect its trade balance (thus lowering GDP growth–an increase of 1 million barrels/day in imports, at $100 a barrel, will reduce China’s GDP by 0.5%), as well as increase the country’s vulnerability to spikes in oil prices.

China oil imports

In a nutshell, we believe China’s economic growth will slow down dramatically over the next several years relative to recent growth. These issues are structural and logical in nature–they are not speculation on our part. Perhaps of more concern is the potential for a systemic crisis in China in 2014/15, which we mentioned in our March 2013 global macro newsletter. Let’s review some charts, starting with a comparison of Total debt-to-GDP ratio across different countries (courtesy Goldman Sachs):

China leverageChina’s total debt load as a percentage of GDP (which includes shadow bank financing, but could be understated due to the relative unreliability of official records) is now the seventh largest in the world, and is the highest among Emerging Market countries. The vast majority of the debt load is borne by her corporate sector. Cyclical industries, such as steel, aluminum, and shipbuilding are especially vulnerable, as these industries are also dealing with overcapacity and slow-down concerns (one would be crazy to purchase securities in these industries right now).

Of course, on a stand-alone basis, the above chart doesn’t say much. Firstly, China–just like most countries in the top 6–can print her own currency. Secondly, and perhaps more important, most of Chinese debt (just like that of Japan) is owned by her citizens. We know this since the Chinese capital account is technically closed. Unlike India, China isn’t at much risk of foreign capital flight. Finally, the country’s US$3.4 trillion in foreign reserves does provide a cushion (or least the perception of a cushion) in the event of a run or capital flight.

History has shown, however, that a more accurate leading indicator for a systemic meltdown is the amount of credit growth leading up to the crisis. For example, Thailand’s total debt-to-GDP ratio increased by 66 percentage points, while Malaysia’s grew by 40 percentage points in the five years leading up to the Asian Crisis. Similarly, the U.S. total debt-to-GDP ratio increased by 46 percentage points during 2002-07. As shown below, China’s credit growth over the last five years (at 56 percentage points) is in that range (interestingly, Brazil’s credit accumulation in the same time frame is also a concern–which is one reason why we are not bullish on the country).

China credit growthCharlene Chu, who oversees credit ratings for Chinese banks at Fitch, observed that over the last five years, Chinese bank assets increased by about $14 trillion, which is equivalent to the size of the entire U.S. commercial banking sector! China’s US$586 billion 2008-09 fiscal stimulus, while well-intended, also added significantly to indebtedness without the commensurate benefits. Logically, studying the rate of credit growth–as opposed to the stock of credit–makes more sense. For example, underwriting standards tend to be more lax in a period of high credit growth, and transparency usually takes a backseat. Also, due to its sheer size and the rapidity of its deployment, much of the 2008-09 fiscal stimulus was misallocated, and the growth of its shadow banking sector has (rightly) become a concern.

Chinese policy makers are beginning to take a pro-active stance in reducing credit growth. But they are stuck in a no-win situation. If they succeed, Chinese economic growth will immediately slow down next year, and is likely to remain relatively low (5% to 8%) for the next several years. By 2020, China’s economic growth should slow down permanently–likely to the 3% to 6% level. Should Chinese policy makers fail to rein in credit growth, the possibility of an economic meltdown becomes more real with each passing year. An ongoing debate within CB Capital suggests it is only a matter of time (especially so in Japan)–likely by late 2014 or early 2015. A Chinese credit event could be triggered by a number of events, such as: 1) global monetary tightening, 2) another global recession, which will immediately hit Chinese exports, or 3) a Chinese property price collapse. Chinese policy makers are now engaged in an unprecedented balancing act.

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