We have raised the red flag about China’s growing debt mountain for some time now (see, for example, our blog “Dragonomics” of April 24th). Progress on rebalancing of the economy, by addressing excess capacity in basic industry and cooling off the property sector and by migrating from an export-driven manufacturing model to a consumption-driven services model (“from mining to dining”), is stalling, in our view (or at least moving at snail-pace). Instead, it seems that China’s leaders are repeatedly reverting to stimulus measures to boost economic growth in the short-term.
Raising the red flag on China’s credit binge…
The Bank for International Settlements (BIS) is the latest institution that sounded the alarm about China’s credit binge, echoing the IMF which made similar noises in June of this year. Chinese debt reached 255% at of the end of 2015. As the BIS explains, it is not necessarily the level of debt that is scary (the level as a percentage of GDP is very high but comparable to that of the euro area), but the speed with which the debt is accumulated. The credit-to-GDP gap (a simple measure to identify the risk of a banking crisis and defined as the difference between the credit-to-GDP ratio and its long-term trend) reached 30%, the highest to date.
The build-up of debt to a large extent has occurred within the corporate sector. As of 31 December 2015, corporate debt stands at about 170% of GDP (rising from 100% in 2008); household debt rose from 18% to 40% over this period. According to Bank of America Merrill Lynch, leverage (measured as gross debt divided by earnings before interest, tax and depreciation) of Chinese companies that issue U.S. dollar bonds as of the end of 2015 was 5.3x compared to 3.9x as of the end of 2014 and to 3.3x for all Emerging Markets companies. Note that global leverage metrics mainly deteriorated due to the collapse of commodity prices and currency depreciation, but that Chinese companies were less affected by these two factors (at least, they did not need to cope with a weakening currency, like Brazil or Russia). Given that commodity prices and currencies have recovered and Chinese companies have continued to borrow heavily, we expect that credit metrics for Chinese companies relative to peers further deteriorate. Furthermore, Chinese companies had the lowest credit spread per turn of leverage (0.53% compared to 1.31% for all companies). So, you are not paid handsomely for buying bonds from these highly-levered companies. A relatively high percentage of debt is short-term (34% versus 22% for all Emerging Market companies and only 8% for U.S. companies), which implies higher liquidity risk in case credit pipes close down. Leverage is highest for State-Owned Enterprises (SOEs) and real estate development companies. SOEs tend to be the largest companies in China and whilst size and scale are important drivers for credit quality and debt capacity, the leverage of SOEs is well above that of global peers, probably based on the premise that the Chinese government will bail out these companies in case of payment difficulties.
Investors and analysts remain sanguine, pointing to China’s low external debt, a high savings rate, a closed capital account and government ownership of major banks and corporates. They think the government can step in and instruct banks to roll over debt. Ray Dalio, the highly respected founder of Bridgewater, an U.S. investment management firm, is one of China’s biggest cheerleaders, stating that China’s economic leadership is very capable and knows what to do when. Indeed, we also do Not have any doubt that the risks are well understood in Beijing as a People’s Daily front page article in May with an “authoritative person” (widely believed to be Liu He, an economic advisor to president Xi Jinping) illustrated. The authoritative person, possibly inspired by our blog in April, gave a stark warning about relying on debt to fuel economic growth, saying that this could lead to crisis and to a collapse in growth.
House for sale…
However, we are not at all sanguine about the consequences of China’s credit binge. We think the risk is largely tied to property. Many corporates dabble in property and, therefore, corporate leverage is to a large extent concentrated in real estate and construction. But households also invest in property, seeing it as an one-way bet to get rich quick. As credit is easy, the capital account closed (barring a few tricks to get money out of the country) and few attractive investment opportunities are available, money ends up in property. This has driven up property prices to stratospheric levels. According to Bloomberg, the average house price in urban China is equal to US$ 1,700 per square meter (in the U.S. it is about US$ 1,300). Prices in first-tier cities went up by 25% over the last year. Yes, the savings rate is high but a lot of it (maybe as much as 70%) goes into housing (as downpayments) at inflated prices. And households are borrowing more money to buy those houses. Most Chinese debt ends up on banks’ balance sheets and is secured by (mortgages on) property (home loans are expected to rise to 30% of GDP, up from 20% only three years ago). Every time when house prices came under pressure, the government acted to counter a drop in house sales so that most people now believe that rising housing prices are as certain as death and taxes. Why is the (local) government doing this? Because, it adhers to an (unsustainable) economic growth target of 6.5% and the property sector is a very important component to reach that goal. We believe that a burst of the property bubble may have a detrimental impact on growth as so much money now is tied up in property. Furthermore, it will dent the faith people have in China’s economic model (you already saw that when stock markets crashed last year). However, the longer the government waits to address the problem, the bigger the correction will be and the longer it will take for the economy to recover.
Ray Dalio would point to a raft of measures that the government announced to address the issue. We are impressed with these announcements as well, but not with implementation. The government seems to do a lot of flagging…
