China’s debt buildup since the global financial crisis ranks as one of the largest in recent history.
A slowdown in credit expansion will lead to a further growth deceleration, but crisis remains unlikely.
The key risks to our view are driven more by domestic issues than external factors.
The two biggest risks are an abrupt reduction in ‘moral hazard’ ...
… and sharp price corrections in the property sector.
1. Market Overview
Risky assets shrugged off the worries on Greece yesterday, with most global stock markets registering gains of more than 1%. Data were very light, with the Japan Tertiary Activity Index pointing to a continued moderate recovery, but growth remaining weak. The Tertiary Activity Index, an indicator of activity in the nonmanufacturing industry, rose 0.3%mom in February, maintaining a moderate recovery trend after slowing down to -5.6% in April 2014 following the consumption tax hike. If the current pace of recovery were to be maintained, the index would return to its pre-tax hike level by end-2015.
Data are relatively light today, and we expect developments surrounding Greece’s sovereign creditworthiness to remain a focus. At the end of the week, Euro area finance ministers will meet in Riga, with the situation in Greece top of the agenda. We doubt an agreement will be reached on this occasion and, at this stage, it seems that negotiations will probably continue into May and could even extend all the way through to the European Council of June 25/26 (see “Greece & Germany Fuel Rates Volatility”, Global Markets Daily, April 17, 2015).
2. Some progress on slowing credit growth, but risks remain
China’s debt buildup since the global financial crisis ranks as one of the largest in recent history (in the 97th percentile of debt-to-GDP changes in a sample of 55 countries over the past 50 years) and is a major global macro concern for investors. Although the risk is significant, our analysis exploring the aftermath of large debt buildups over the past half-century suggests that credit booms do not always end in deep recessions or banking crises. In our view, the need to slow down credit expansion will lead to a further deceleration in GDP growth, which typically decelerates by at least 3-4pp after credit booms, and a full-blown crisis remains unlikely (see “Untangling China’s credit conundrum”, January 26, 2015).
We have seen some progress by policymakers in reining in excess credit. This can be seen from the slowdown in total social financing (TSF) growth, with the stock of TSF outstanding growing 12.7%yoy in March 2015, compared with 16.1%yoy in March 2015 (think they mean Feb 2015). An important reason why the growth in TSF has slowed stems from risk control, as policymakers have curbed growth in two of the riskiest segments of China's credit market – namely, trust financing and local government financing vehicle bonds (see “Slowing credit growth in China partly due to risk control”, Global Markets Daily, March 25, 2015). Despite the progress so far in cooling down credit growth, challenges remain. In particular, the legacy issues on the buildup of the significant amount of credit are still to be addressed. In this piece, we highlight what we think are the key risks to our view.
3. External debt: More an opportunity than vulnerability, for now
The rapid build-up of China’s external debt has drawn considerable investor attention. Starting from a relatively low base, external debt in China (based on BIS data) has increased more than five-fold over the past five years. This is impressive growth even compared with other Asian peers, where external debt growth averaged around 100% over the same period, and likely reflects lower offshore yields and the expectation of CNY appreciation. Despite this rapid rise, the level of external debt remains relatively low in China, at about 8½% of GDP. The fairly low level of external debt in China points to a large potential to diversify domestic financial risks to the global markets going forward. In particular, we see scope for the government to continue expanding quota-based foreign investment channels (e.g., the RMB Qualified Foreign Institutional Investor program and the PBoC bond program), which can allow more foreign funding to finance Chinese growth, while keeping risks of a 'sudden stop' relatively low. The key risks, in our view, are therefore not from external factors, but driven more by domestic issues.
4. Key risk #1: An abrupt reduction in moral hazard
In our view, the moral hazard issue is one of the most important, if not the most important, issues to address when dealing with the excess credit that has built up in China. The propensity for creditors to lend to companies or sectors that carry strong 'implicit' government support creates distortions, preventing a more efficient allocation of credit. To deal with this issue, China’s State Council announced a new set of guidelines in October last year aimed at strengthening the supervision and management of Chinese local government borrowings. The new guidelines aim to reduce moral hazard by stating that the central government cannot be responsible for repaying local government indebtedness, and local governments cannot be responsible for repaying corporate sector debts. The guidelines also stated that future funding needs by local governments should no longer be conducted through local government financing vehicles (LGFVs) and should be met via the recently introduced municipal bond program.
If the guidelines are firmly implemented and changes take place too quickly, we believe that this could lead to a dislocation of credit markets. With much of the lending in recent years directed to state-related entities on the assumption that there is implicit government backing, an abrupt change to that assumption may lead to significant uncertainty and result in lenders becoming reluctant to extend credit. We believe that policymakers will adopt a balanced approach in their implementation. This would represent a gradual change to reduce moral hazard risks, while improving the accountability of existing debts, and would better define the responsibilities of the central government, local governments and corporates for future indebtedness. This is why, although we expect more credit stresses to emerge (note attached), we think such stresses will take place in a gradual manner.
5. Key risk #2: Property price slump
A housing boom helped China recover quickly from the global financial crisis, but was accompanied by large price increases, rising leverage, and high and rising levels of vacant inventory – conditions reminiscent of housing bubbles in other countries (see “China’s housing boom in international context”, Global Economics Paper: 225, October 16, 2014). Chinese home sales, prices and construction starts weakened in 2014, prompting concern about the potential impact on economic activity and financial stability. In addition, real estate is heavily used as collateral for bank lending, and sharp price corrections may cause lenders to raise concerns on the safety of the collateral. As such, this remains a major risk factor, but we believe that policymakers have powerful tools to address housing weakness. (a five-year tight grip on the property sector is just being relaxed)
Based on the National Bureau of Statistics 70-city housing price data, average housing prices in the primary market have fallen on a mom basis since 2Q2014, and the latest data show that average property prices fell by -0.5%mom (seasonally adjusted by GS) in March, or -5.9%yoy. The weakness in the property sector prompted policymakers to introduce a number of easing measures, with a number of mortgage loosening policies in September 2014 (see here). And in late March this year, further measures were introduced including the lowering of the down-payment requirement for second homebuyers to 40% from the current 60% to 70%, and the lowering of the threshold for property sales tax exemption (see here for more details). Together with the recent interest rate cuts, we believe these measures will have a positive impact on housing affordability, and should help drive property transaction volume improvements in the coming months.