“China: A Rolling Loan Gathers No Loss” – Kyle Bass
Five years ago, China was viewed by many as both the world’s most resilient economy and its rising superpower. As the West faltered it was the Chinese economy that acted as the world’s motor for growth. The picture today however is very different and rather more precarious. Weakening demand, disinflationary pressures and huge levels of debt are challenging China’s economic resilience, putting pressure on both its growth rate and investment in the country.
To understand the current situation in China, it is first important to understand the factors behind its recent economic boom. In particular, China’s growth has been fuelled by a huge expansion in domestic credit. Since the end of 2008, its debt to GDP ratio has gone from 147% to over 250%. Given the size and growth rate of China’s economy, this increase has translated into $17 trillion dollars of new lending over the past three years.
Whilst this credit boom has fuelled growth, China’s economic expansion has been extremely unbalanced. China is struggling to find the consumer demand, either globally or domestically, to match its increased investment. As a result, there is now growing structural overcapacity within the country, as seen most recently in Chinese new house prices, which have fallen over the last four consecutive months, and flagging factory output, which has suffered a similar fate.
Further to this, there are now significant issues with Chinese asset quality. Just as China’s credit bubble has expanded, so to have its levels of bad debt. Whilst official non-performing loan ratios suggest levels of bad debt are around 1%, in reality this number is likely to be significantly higher. For one, there is a tendency within the Chinese banking sector to extend and restructure bad debt rather than declare it as non-performing and force firms to default. As a result, significant portions of capital sit misallocated within the economy. Whilst the Chinese government has vowed to clean up its financial system, slowing growth is putting substantial pressure on its economic growth targets, which may delay any potential banking sector reform.
Finally, China is also facing disinflationary pressures. Consumer price inflation rates have fallen 1% since May. Further to this, recent PPI numbers indicate that producer prices have fallen 3.3% over the last year as part of a 34 consecutive month decline. Not only will this put pressure on China’s ability to service its mountain of debt, but it has also lead China’s central bank, the People’s Bank of China (PBoC) to cut the benchmark interest rate in an effort to further ease monetary conditions. In other words, China is relying on more credit to paper over the problems it faces.
Given these structural weaknesses, how then has China been able to finance this credit boom? In truth, the answer to this question is as much about the actions of the Federal Reserve as it is about the PBoC. The Fed’s decision to implement QE on a monumental scale following the collapse of Lehman Brothers and issue aggressive forward guidance created huge carry trade opportunities for FX investors not only in China but across the world’s emerging markets. With US interest rates having bottomed out and the renminbi appreciating against the dollar, demand for Chinese debt surged during this period and the capital flowed in.
However, as the dollar rallies, there is a risk that this carry trade may reverse in a major way. What does that mean for China? We are already beginning to see capital return to the safety of the greenback and as further pressure mounts on China carry trade positions this is likely to increase. Any escalation of capital flight and loss of liquidity would expose China’s aforementioned structural weaknesses, significantly impacting asset value and future growth, as well as a bringing about a potential devaluation in the renminbi.
Going forward, China faces a number of risks over the medium term. In the event that the carry trade flips, PBoC will have to either raise interest rates or use its FX reserves to defend the renminbi, both of which carry risks. Should PBoC decide to raise interest rates, they risk stalling economic growth. By contrast, using FX reserves will make the Chinese economy more vulnerable to capital movements in the future. Neither method addresses the deteriorating fundamentals at the root of China’s problems. It appears that China will need to face its demons sooner rather than later.
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