China not facing a debt-driven collapse, say fund executives

China's debt levels have risen sharply since the 2008 crisis but Beijing will be able to manage the deleveraging process, argue executives from Matthews Asia and BlackRock.
China not facing a debt-driven collapse, say fund executives

China’s debt levels have reached alarming levels, according to the Bank for International Settlements (BIS), but some investment professionals argue that Beijing is on top of things.

Mainland debt may have been swelling rapidly and the debt-to-GDP ratio seems high, but there’s no collapse coming, said Andy Rothman, investment strategist at US fund house Matthews Asia. In fact, the situation offers opportunities, as most people are positioning for a market crisis, he told AsianInvestor.

"Alarming" figures

According to BIS data released last week, China’s debt has grown to alarming levels. The credit-to-gross domestic product (GDP) gap – the difference between the credit-to-GDP ratio and its long-term trend – stood at 30.1% as of end-March. A reading above 10% is a cause for concern, said the report.

BIS put the country’s total credit outstanding at $27.2 trillion, or 255% of GDP, as of March 31. That is lower than the eurozone at 271%, the UK at 266% and Japan at 394% – but China’s debt has grown rapidly from 147% of GDP at the end of 2008.

The mainland debt problem is serious, Rothman said, but the risk of a hard landing or banking crisis is low, because China’s potential bad debts are corporate rather than household debts, and were made at the direction of the state, by state-controlled banks to state-owned enterprises (SOEs). Hence China’s debt is manageable, as the government controls when and how it gets dealt with, he noted.

Seeded in the crisis

The problem originated in the 2008 global financial crisis. Prior to the crisis, China’s debt-to-GDP was relatively stable at about 150%. To tackle unemployment and the risk of social instability resulting from the post-crisis collapse in exports, Beijing spent money to accelerate the construction of public works projects, Rothman noted in a report released this week, Cleaning up China’s debt Q&A.

This infrastructure construction was funded by bank loans, most of which went to SOEs responsible for managing the construction projects, although much of the work was carried out by privately owned contractors. So China’s outstanding debt is mostly in the SOE sector, with some held by corporates.

On the corporate side, privately owned small and medium-sized enterprises (SMEs) are the engine of China’s economic growth, accounting for more than 80% of employment and almost all new job creation, as well as most investment.

But they are deleveraging, Rothman said. The liabilities-to-assets ratio of privately owned industrial firms fell to 51% in 2015 from 59% in 2006.

Moreover, Chinese household debt is relatively low, at about 40% as of end-2015, compared to 80% in the US, 90% in the UK and 60% in the eurozone,.

Debt cleaning

What will help solve the debt overhang is a continuous acceleration in the recognition of non-performing loans (NPLs) in the banking system, Rothman said.

Chinese banks’ NPL ratio stood at 2.15% as of end-May, said Yu Xuejun of the China Banking Regulatory Commission in July. That is a big increase from 1.4% at the end of 2015, according to research published this week by US fund house Pimco. If China can successfully manage the deleveraging process in the corporate sector, then the NPL ratio in the banking system should peak at around 6%, noted Pimco; otherwise, the ratio will likely continue to rise.

This process will involve taking the bad loans off the balance sheets of the SOEs, transferring them through the banks that issued them to state-backed asset managers, added Rothman. There are four such ‘bad banks’ in China: China Great Wall, China Orient, Cinda and Huarong.

Over time, the SOE debt level will gradually fall, but the government’s debt-to-GDP ratio will gradually rise, Rothman conceded. The fiscal deficit-to-GDP ratio was 2.4% at end-2015, and the government expects it to reach 3% by the end of this year. And it is likely to continue rising, he noted.

Clearly, then, China faces some major issues, Rothman noted, but the situation outlined above is a very different story from the gigantic crisis that many people are expecting.

There are others who broadly support Rothman's view. Helen Zhu, BlackRock’s head of China equities, is confident that mainland debt growth will stabilise and Beijing will succeed in its deleveraging aims, potentially in five years or so.

Speaking at Bloomberg Markets Most Influential 2016 forum this week, she was positive on the government’s attempts in re-allocating credit to private companies that are short of liquidity.

The government has begun forcing implicit capital guarantee to be broken, allowing poor-quality credits to default and re-allocating credit to more productive companies. As a result, investors will face turbulence in the near term, Zhu said. “It is going to be a long and painful process, but it has started.”

With additional reporting by Toby Yiu.

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