Chinese corporates will have to cut their debt levels at some point, and when they do, a recession will ensue, argues Gillem Tulloch, founder and managing director of independent research house Forensic Asia. That will be necessary to create a more sustainable model for economic growth, he adds.
Tulloch was speaking on a panel in Hong Kong last week – titled ‘Should investors be concerned about a China slowdown?’ – hosted by Kuwaiti asset manager Asiya Investments, which recently opened an office in the city.
Other speakers were less downbeat in their assessment of China’s economy, but all four agreed that substantial reform is needed if the country is to achieve better quality growth.
“The quality of Chinese growth has been appalling over the past five years. There has to be a cleansing of the system,” says Tulloch. “You just have to look at corporate balance sheets – and I’m talking about listed companies that have access to capital markets. You cannot sustain these levels of growth. You have to have a recession – it’s an inevitability.
“[The Chinese government] can delay it for as long as they want, but they’re just going to make the situation worse,” he adds. “There has to be a period when GDP growth contracts – and then China will become a consumer-orientated society because investment will collapse.”
When the credit stimulus ends, Chinese companies will cut capital expenditure to generate free cashflows and restore solvency in their balance sheets, argues Tulloch – and that will lead to “a good old-fashioned recession”. Then it will enter a protracted period of slower growth as companies continue to deleverage their balance sheets, he says.
He points out that Chinese corporates are as leveraged, in terms of debt to operating capital, as those in Southeast Asia just before the Asian financial crisis in 1997.
Moreover, banks can’t continue to lend at the current rate, because they don’t have the capacity to do so any more, adds Tulloch – they’re running out of deposits and their loan-to-deposit ratio is capped out. In addition, they’ve seen a big rise in loans since June.
Another to strike a particularly bearish note is Ha Jiming, chief investment strategist of the investment strategy group in the investment management division at Goldman Sachs.
He argues there are two factors slowing the economy in China – overcapacity and rising prices – and that any economic adjustments in China will not be smooth. “Capacity will continue to build up until in future some time it will collapse,” adds Ha. “That’s the growth model in China.”
A recession has not yet arrived because the government has deployed policy tools to jump-start the economy, he notes, but at some point rising prices will deplete the tools that are available.
The Chinese economy has been able to grow 10% a year for two decades because of cheap labour and cheap capital, and with the help of the one-child policy resulting in not so many elderly people, “even fewer kids” and a lot of people who can work. That means the savings rate is high and labour is abundant.
But Ha believes there will be an inflection point in 2015, after which China’s population will age sharply because of the one-child policy. The savings rate will therefore fall and the labour supply will be more limited, resulting in higher interest rates and wages. As a result, banks’ deposit levels will fall, reducing their ability to lend.
Even the more bullish members of the panel expect a slowdown in GDP growth to around 6% by 2020.
But while Lu Ting, head of Greater China economics at Bank of America Merrill Lynch, makes that forecast, he does not think the ratio of Chinese corporate debt to GDP – at 110% – is “surprisingly high”.
Moreover, he argues that it is not necessary to shrink balance sheets to achieve deleveraging. Better functioning equity capital markets are needed.
One reason for the rising leverage of Chinese corporates in the past few years is that China’s equity capital markets have failed to function well, he says, citing the very small number of IPOs over the past three years.
“The best way for China to deleverage is to make it easier for Chinese corporates to raise equity capital and to start IPOs again,” says Lu, and also make the ECM more transparent. Stock market reform, he says, is the most important change that China has to make.
“The CSRC [China Securities Regulatory Commission] should do a much better job to convince people that China not only has the best economic growth in the world, but also has profitable, quality companies that can give shareholders a good return,” adds Lu,
John Woods, head of Asia fixed income at Citi Investment Management in Hong Kong, was more optimistic, arguing, for one thing, that other Asian stock markets are relatively decoupled from the Chinese economy.
While China has slowed from 12.5% GDP growth to 7.5% over 13 consecutive quarters, he notes, the MSCI Asia ex-Japan index has risen 33%. What's more, over the same period, an investment in Southeast Asia would have returned 44% and money put into Asia US dollar-denominated bonds would have gained 21%. By the same token, between 2000 and 2002, when China grew rapidly, the MSCI Asia ex-Japan fell by 35%.
Woods is also relatively upbeat about the Chinese economy itself, which is widely forecast to see GDP growth of around 7-7.5% for 2013. “It’s very difficult to adjust an economy growing at 12%, but it’s much easier to adjust one growing at 7%.
“China growing at 12% based on fixed asset investment is much worse than China growing at 7% by a mix of exports and consumption,” he says. “The quality of the growth is the most important point.”
Woods therefore agrees with Ting’s expectation that GDP growth will slow to a more sustainable 6%. “That will allow for adjustment, and is investor-positive.”