At one level, this seems to be China’s moment. At a time of growing political incoherence and diminished leadership in the US and Europe, China seems to be the only adult in the house, taking the leadership on issues of critical importance to the globe such as trade and climate change. On the surface, the economy looks better, with economic growth stable, receding deflationary pressures and strong consumer confidence.
But, just as investors breathed a sigh of relief, new risks seem to be emerging. The financial sector is raising questions, while the rapid depreciation of the renminbi has increased speculation that a further fall in the currency could destabilise emerging economies. Given how important China is to the world economy and Asia, we need to understand how serious these risks are and what could go wrong, starting with the growing financial challenges.
Financial indicators are flashing red
The rapid pace at which China’s credit binge unfolded continues to create stresses in the financial system. Authoritative commentators are increasingly warning of rising risks for a variety of reasons:
- The Bank of International Settlements has turned more cautious. BIS employs a measure comparing the actual credit-to- GDP ratio with its trend line. This so-called credit-to-GDP gap has reached 30.1 in China. Since BIS believes any level exceeding 10 signals an impending crisis, it sees a high risk of China suffering a banking crisis within the next three years.
- The increasing dependence on wholesale financing raises alarm bells. A number of analysts have pointed to financial ratios that also signal rising chances of a shock. The Financial Times calculates a ratio of private-sector credit outstanding to standard commercial bank deposits to quantify the dependence of lenders on more risky wholesale funding — this ratio surged to 117% by the end of March this year from 84% at end-2008. On the other hand, S&P Global Ratings has a separate measure called the adjusted loan-to-deposit ratio, which includes a number of off-balancesheet items. This ratio has risen over time, reaching 80% at end- June for the system as a whole, but with some of the smaller banks already over the 100% level. Clearly, too many banks are resorting to off-balance-sheet lending through special purpose vehicles and sales of so-called wealth management products. While this trend is starting off from a low base, it raises the risk of contagion when a crisis of confidence occurs and credit flows dry up. There is no imminent threat, but the trend is worrying.
- Corporate debt levels are high and rising. They now stand at 210% of GDP as at 1Q2016. The corporate debt service ratio is also on an uptrend. With the economy slowing and reforms to reduce overcapacity moving at glacial pace, corporate profits will come under greater pressure, resulting in a more onerous debt servicing burden. BIS estimated that the debt service ratio has reached a troubling level of 5.4.
- The housing bubble is real. Soaring housing prices have prompted the authorities to roll out a slew of measures to curb property prices, but the housing market remains at elevated levels. Housing prices in Tier-1 (and even some Tier- 2) cities have soared more than 20% in 2016 year to date. Weak affordability ratios reflect how unsustainable this housing rally is. In Tier-1 cities, the ratio of house prices to household disposable income was close to 15 times at end-2015 and is estimated to be 18 to 20 times currently.
Plummeting private investment means growth will continue to slow
Private-sector fixed asset investment (FAI) in China remains at depressed levels, despite a recent small bounce that resulted from investment in the unsustainable housing bubble. Private FAI increased 2.9% y-o-y in October, up from 2.5% in September and 2.1% in August — a far cry from the 10% growth rates seen in 2015 because of massive excess capacity in many sectors of the economy. With private-sector FAI making up more than two-thirds of total FAI, its weakness cannot be offset easily by a ramp-up in government or SOE investment. Moreover, such boosts to public-sector investment tend to be unsustainable by exacerbating existing imbalances such as excess industrial capacity.
An abrupt rise in inflation expectations could be destabilising
After many years of persistently falling producer prices and very low consumer inflation, China is now seeing a return of inflation.
- Factory gate deflation has essentially ended after nearly five years of contraction seen in the Producer Price Index. The PPI has registered two successive months of increases while consumer inflation has ticked up a little in recent months.
- Core inflation is rising. Digging deeper into the price data, we find that non-tradeable inflation is growing, a sign that domestic supply-demand imbalances could lead to future inflationary pressures.
Will these early signs of inflation grow into a more pronounced acceleration in inflation? A key driver of inflation is the amount of slack in the economy, the so-called output gap. This measure now stands at its highest level since 2008, suggesting a significantly high rate of utilisation and a portent of intensifying inflationary pressures. If expectations of inflation spike up as a result, that could be destabilising — for one, it could lead to capital outflows as higher inflation will start people chattering about a devaluation of the renminbi.
So far, inflationary risks are contained. But if monetary easing persists in an environment of rising inflation, it will not be long before inflation expectations surge and destabilise the economy. This limits the authorities’ room for manoeuvre in using loose monetary policy to sustain growth.
Could the renminbi be devalued more aggressively?
More forecasters are talking about the renminbi depreciating steadily from the current level of around 6.9 to the US dollar to around 7.2 or 7.3. A gradual adjustment to the weaker level over time, which does not upset China’s main trading partners, will not cause too much hand-wringing; only a more abrupt and sharper devaluation would. That does not seem likely, but that has not stopped some analysts from speculating about this. The currency’s step-by-step depreciation has actually improved its underlying cost competitiveness by around 6% so far this year. It does not really need to aggressively boost its export competitiveness.
Moreover, China continues to pile up a large current account surplus, which amounted to about 2.5% of GDP in 3Q2016. This external surplus is set to rise sharply in the coming year — as investment cools relative to how much Chinese companies and households save, the current account surplus can only grow sizeably. With such surpluses, it would be difficult for China to persuade its trading partners to accept a renminbi devaluation. We believe the authorities will avoid taking such a risk.
Could protectionism sink China?
In fact, a growing current account surplus even without further renminbi depreciation could stoke protectionist pressures as protectionist-minded leaders see other countries’ surpluses as somehow unfair. US President-elect Donald Trump is unlikely to follow through with his threats to impose a 45% tariff on China once he is inaugurated in January. But there are other measures he can use against China. Protectionist actions targeting China were already increasing even under the current administration. It can only get worse under a Trump Administration that is less friendly to China and that will find it convenient to have a foreign scapegoat as it rushes through controversial policy changes that are bound to provoke strong political reactions within the country.
However, no US administration would want to spark off a trade war, given the risks to the country’s interests such a war would entail. Despite its anti-China rhetoric during the presidential campaign, the new administration will learn that a constructive relationship with China is in the US’ interest and that China should not be pushed too far.
So, where does that leave China?
The Chinese economy has been on a more stable footing in the recent two quarters on the back of fiscal and monetary policy support. However, some of the measures used to underwrite continued economic growth are short-term salves that cannot resolve fundamental long-term issues. The Chinese authorities need to accept that China needs to grow at a more modest pace to be sustainable. Once they accept that and rein in some of the excessive credit growth taking place, we could see the risks contained.
In that case, which is our baseline scenario, China will, at worst, endure episodic stresses, which are mostly containable by policy measures.
However, if credit growth persists at high levels, a more disturbing scenario is possible. Excessive credit growth will lead to more overinvestment and consequently deepen the already-serious overcapacity. That would reduce pricing power and margins and thereby squeeze profits and cash flows, squeezing firms’ ability to repay their massive debts. Debt-related stresses could then cause banks to tighten credit conditions, resulting in a credit crunch, which causes private investment to plunge, producing a downward spiral in the economy. Deft policymaking is required to avert such a downward spiral, and we think it will be forthcoming.
Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy.
This article appeared in the Corporate of Issue 756 (Nov 28) of The Edge Singapore.
