Four months ago, when we published our previous Global Economic and Markets Outlook ‘Big Trouble in Little China’ – China’s economic slowdown was plain to see. Output had risen by just 1.5% in the first quarter of the year, and that was the slowest rate of expansion in two years. Had the economy continued to grow at this rate through the remainder of 2014, growth for the year as a whole would have been just 6.8% – some way short of the government’s official target. It seemed inevitable that policy makers would engage in further stimulus. And they did, as we set out below. What was in doubt was whether the authorities would act quickly enough to prevent China’s mounting NPL problem from spreading rapidly through China’s banks and shadow banks. And here, the jury is still out.
Government spending up. Credit up.
China’s ambitious reform agenda has been side-lined in recent months, with policy makers focused instead on stimulating the economy with yet more largely wasteful government expenditure. The purse strings have been loosened again.
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Monetary tools have been deployed too. In the twelve months to June, total social financing (or TSF), a measure of the total amount of credit offered to non-state entities, hit a nine-month high. And China’s banking regulator has also lent a hand. On 28th July it was announced that the method for calculating banks’ loan-to-deposit ratios is set to change. This will facilitate yet more lending, as it allows banks to lend more without breaching the 75% threshold currently in place under Chinese law.
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It is working – for now
The HSBC manufacturing PMI was stuck below 50.0 throughout the first quarter of 2014. However, in June it climbed above 50.0, and in July it hit an 18-month high of 51.7. In contrast to the situation three months ago, China is no longer at the bottom of the global ‘PMI’ league table.
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In the four-quarters to 2014 Q2, China’s economy expanded by 7.5%, in line with the government’s official target for the calendar year as a whole, and 0.1 percentage points stronger than the equivalent figure for Q1. Growth is, of course, still a long way below the average annual rate of more than 10% seen during the previous decade.
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But massive overinvestment …
As we set out in ‘Big Trouble in Little China’, China has built up a vast amount of excess productive capacity. Since China joined the WTO in 2001, its ratio of investment to GDP has climbed from 35% to almost 50%. A good portion of this rise occurred in the aftermath of the financial crisis. Faced with a reduction in external demand for its goods and services, China ought to have raised domestic demand by encouraging more household expenditure. Instead it increased its productive potential still further.
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China’s property markets provide just one illustration of the degree of overinvestment that has taken place. The quantity of vacant floor space in China has ballooned in recent years – in May commercial and residential space ‘waiting for sale’ exceeded 500 million square meters. This is feeding through to prices. In both May and June a typical new home in China’s largest cities sold for less than it did the previous month.
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… implies a massive non-performing loan problem
The China Banking Regulator Commission estimates that non-performing loans (NPLs) held by the country’s ten biggest banks amounted to some 1% of GDP at the end of last year. We have long doubted these official statistics, and so four months ago we put together some of our own.
A loan made to a company for the purposes of investment will turn bad whenever the project that it is used to finance fails to earn a return that is sufficient to cover the interest cost. In that regard investment returns, both on average and across companies, are a key determinant of the magnitude of a country’s non‐performing loan problem. Under fairly standard assumptions about production technology the returns to investment, measured by the marginal product of capital, are proportional to the inverse of the capital / output ratio. In other words, as capital rises relative to output, the returns to investment fall. But not all projects earn the average return – some do better and some do worse.
We calibrate our model of China’s non-performing loan problem using the experience of Japan through the 1990s and into the 2000s. By comparing the average marginal product of capital in Japan with both the cost of finance in that economy and the quantity of non-performing loans, we can obtain an estimate of the variability of investment returns around the average. If the variability of returns in China is the same as that in Japan – and we have no grounds to believe that it would be substantially higher or substantially lower – then we estimate that, following a reduction in the average marginal product of capital from 8% to 4%, the stock of non-performing loans in China has more than doubled as a share of GDP from 8% in 2008 to 17% in 2013 – much higher than the official 1% estimate.
In its latest Annual Report, the BIS draws conclusions that are very similar to our own. It finds that China is now the world’s most over-leveraged economy, and that the ratio of private sector debt to GDP needs to fall by more than half in order that debt-servicing costs become manageable.
Creaking at the seams?
The steady drip, drip, drip of bad news coming from China’s troubled financial sector seems to be gathering pace. At the start of July, a Chinese trust fund announced that one of its Wealth Management Products, the $200 million ‘Credit Equals Gold #2’, may face trouble making payments after a Shanxi coal mining company defaulted. The company did indeed miss the payment and the product’s maturity was extended by 15 months in the hope that enough cash could be raised through a fire sale in order to repay investors. Moreover, in July ‘Huatong Road & Bridge Group Co Ltd’ announced that it was in danger of failing to repay the principal on a maturing one-year bond issue. Just one week later it ‘found’ the RMB 400 million needed to avoid default, while declining to name the mystery benefactor. Finally, last week it was reported that China’s banking regulator had encouraged governments in five provinces, including Shanghai, to set up asset management companies to buy up bad loans from troubled lenders.
Viewed in isolation, these announcements are innocuous enough. Taken together, however, there are perhaps echoes of the early warnings signs received in the run-up to the collapse of Lehman Brothers bank in late 2008. The Chinese authorities are almost certainly intervening behind the scenes in an attempt to prevent contagion. But it is too early to say whether they will be successful. By turning on the monetary and fiscal taps, China’s policy makers succeeded in generating a modest rebound in activity through the second quarter. But the risk of a hard landing in China has not gone away. And while China continues to rely on the old methods of monetary and fiscal largesse to kick-start the economy, the greater those risks will become.
This research note is provided by Fathom Consulting. All of the charts below and many many more, covering a range of topics and countries on both the macroeconomy and financial markets are available in the Chartbook to Datastream users at www.datastream.com. Alternatively you can access Fathom’s Chartbook at www.fathom-consulting.com/TR.
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