China: kicking the can down the road

China: kicking the can down the road

Marcus Wright, RBS Economics, April 20161

Information classification: Public/Internal/Confidential/Secret 2

What’s this all about?

• China has reverted to what it knows best – engineering a credit boom to support investment.

• It will likely delay China’s hard-landing.

• But only temporarily. China has been getting less growth bang for its credit buck since the crisis.

• It doesn’t change our fundamental view of China’s economy – it remains beset by major problems including over-capacity in key sectors and hidden non-performing loans in the banking sector. The proverbial can is being kicked down the road.

• It’s a short-term positive for the global economy. It might make 2016 “okay, but not great” rather than deteriorate further. But it won’t be enough to throw lower for longer off track.

• China’s medium-term financial stability risks have increased. And the UK is financially exposed.


• China has engineered yet another credit boom to arrest the sharp drop in growth.

• New financing into the economy in Q1 was the strongest on record.

• If all that financing was an economy on its own it would be the world’s 16th biggest, not far off the size of Mexico.

• While we previously stated that policy making was not calibrated to the economy’s needs it has now shifted even further away from what is desired.

• The proverbial can is being kicked down the road.

0200400600800

1,0001,2001,4001,600

China Q1 New Financing v Economy Ranking($ Bn) China - Q1 2016 New Financing

Source: Bloomberg , IMF

1. China has reverted to what it knows best

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2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

China - New Financing(Yuan Bn)

Source: Bloomberg


• China is locked into a credit-intensive form of growth.

• The credit binge is being supported by fiscal expansion - the planned fiscal deficit for 2016 will be the biggest in at least 34 years.

• China on the face of it has plenty of room for fiscal expansion. Public debt is merely 30% of GDP.

• But that excludes local government debt. It could be as well over twice the 30% figure.

• And the government will likely have to pay for a significant banking sector bailout in the coming years.

2. It’s the third distinctive credit wave since the crisis, and it’s supported by fiscal expansion

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-1

0

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2 China - Fiscal Balance(% of GDP)

Source: IMF, China NPC

2016 Targetannounced at NPC

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500

1,000

1,500

2,000

2,500

2002

2003

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2016

China - Monthly New Financing(Yuan Bn)

Source: Bloomberg

1. Post-CrisisResponse

2. The post-crisis response credit

pick-me-up

3. 2016 Boom


• The renewed credit deluge seems to have arrested the decline in growth.

• After slowing significantly in 2015, much more than the headline figures suggest, China’s growth may have bottomed, temporarily at least.

• Real estate and infrastructure investment growth rates have risen into Q1.

• Even steel seems to be on the up.

• The usual build-up of steel inventories over the winter was much less than usual. And it’s already being drawn down.

3. It seems to have got traction

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30 China - Fixed Asset Investment(% Y/Y Change)

Real EstateInfrastructureManufacturing

Source: Bloomberg

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4,000

5,000

6,000 China - Steel Futures

(CNY)

Source: Bloomberg

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2012 2013 2014 2015 2016

China - Winter Steel Inventory Build

(Rebar)

Source: Bloomberg


• The authorities have engineered yet another house price boom.

• Easier credit and a reduction in the required deposits for first-home buyers (from 25 to 20%) and second home buyers (from 40 to 30%) have helped.

• House prices in the largest cities (Shanghai, Beijing, Shenzhen, Guangzhou) rose a staggering 30%y/y in March.

• But the market remains afflicted by oversupply.

• China’s house prices are prone to wild swings. The next downturn is unlikely to be too far away.

4. House prices are on the rise but…..

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2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

China House Prices(Newly Built, % Y/Y Change)

Tier 1 Cities Tier 2 Cities Tier 3 Cities Source: Bloomberg

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20 China - House Prices v Floor Space for Sale

House Prices (All Cities - % Y/Y Change) - LHS

Residential Floor Space for Sale (10,000sqm) - RHSSource: Bloomberg


• China’s post-crisis credit waves have been getting less growth bang for their buck.

• More and more capital is needed to produce an extra unit of output.

• The return on capital has been declining steadily since the crisis, as it has across emerging markets as a whole.

• So there are doubts about how long this latest growth fillip will last.

• It could fizzle out before the end of the year.

5. Less growth bang for its credit buck

2

2.5

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5

5.5

1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

China - Incremental Capital Output Ratio

Source: OECD

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2001 2003 2005 2007 2009 2011 2013 2015

MSCI China - Return on Capital(%)

Source: Bloomberg


The economy remains beset by:

• an excessive reliance on investment to drive growth

• a structurally low share of GDP going to household incomes

• over-capacity in key sectors

• hidden non-performing loans in the banking sector

• ad-hoc, reactive policy-making that fails to address the underlying distortions in the economy – the transition to a less debt-addicted, less investment-driven growth model remains some way off

6. It doesn’t change our view on China


• China’s rapid debt build-up has been matched by sharp rise in the cost of servicing that debt.

• It is widely agreed that China’s banks are sitting on non-performing loans well in excess of official figures. But estimating the true size of the problem is very difficult.

• Our own estimate is the NPL ratio is around 25%. In the most pessimistic scenario NPLs are closer to 35%.

• We maintain the view that China won’t experience an out and out crisis.

7. A more painful day of reckoning awaits

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2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

China - Debt to GDP and Debt Servicing (%)

Household and Corporate Debt as % of GDP - LHSDebt Servicing as Share of GDP (%) - RHS Source: BIS, Bloomberg

0%

5%

10%

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Reported Optimistic Central Pessimistic

China - Estimating Banking Sector NPL Ratio (%)

Source: IMF, Penn World Tables, Bloomberg, Macrobond, RBS Economics

Information classification: Public/Internal/Confidential/Secret

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200

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2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Financial Exposure to Ch & HK ($ Bn)

World UK

Source: Macrobond 10

But the consequences of its credit boom will be far from painless. In the coming years we think China will experience:

• a balance-sheet recession (the debt hangover) as debt-burdened corporates prioritise debt minimisation;

• an impaired (eventually) banking system, constraining the reallocation of credit and productivity growth;

• a hangover of misallocated labour from the financial boom, also constraining productivity growth;

• an inadequate reform effort.

Our ‘not a blow-up, but many difficult years’ view on China remains.

8. China’s challenging future

The risk from financial exposures

• It’s too early to tell whether global financial exposures to China have increased in recent months in tandem with the credit boom.

• But even if it hasn’t, the latest credit deluge increases medium-term financial stability risks in China.

• The UK’s exposure to China is a concern.


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China: kicking the can down the road