China Watch – Digging into the debt dynamics

by: Arjen van Dijkhuizen

In this publication: April’s set of macro economic data weaker than in March. Still, we have seen signs of macro economic stabilisation in recent months. Stimulus filters through, resulting in a rebound of the real-estate sector. Credit growth still outpacing nominal GDP growth. Rising debt level is a key risk, though mainly a domestic, longer-term issue. Policy focus shifts back to structural issues, but no radical changes expected.

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Overview: Short-term stabilisation versus rising longer-term risks

Although the April set of macro economic data was disappointing compared to March, the broader picture points to near-term economic stabilisation. The stepping up of fiscal stimulus, the easing of macro-prudential regulation, such as downpayment requirements, and an ongoing accommodative monetary stance have contributed to a pick-up of activity in the real estate sector, which helped to overcome drags from heavy industry and financial services. Moreover, after falling rapidly in late 2015/early 2016, FX reserves have stabilised in recent months, also reflecting temporary US dollar weakness. All in all, China hard landing fears have eased compared to mid-2015 and early 2016. However, as we explained in our April China Watch, Short-term gains, long-term pains, the success in near-term economic stabilisation comes at the cost of rising longer-term risks, particularly in the form a further rise in already high debt levels. Now that additional stimulus has facilitated economic stabilisation and with warnings relating to China’s debt levels and other risks coming to the fore again, Beijng’s focus seems to shift back a bit to supply-side reform and structural issues such as deleveraging.

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April economic activity data weaker than in March …,

The macro economic data for April published over the past weeks were generally a touch weaker compared to March, although this was to a certain extent to be expected given some seasonal distortions. Still, the April data are generally better compared to the levels seen in late 2015/early 2016. Growth of industrial production (6.0% yoy) and fixed investment (10.5% yoy) slowed in April compared to March, but remained higher than the levels seen in early 2016. Retail sales fell to 10.1% yoy (March: 10.5% yoy), being dragged down by a cooling of car sales. Bloomberg’s monthly GDP estimate fell to 6.9% in April, down from a cyclical peak of 7.1% in March, while remaining close and even a touch higher than the official GDP numbers (with 6.7% yoy reported in Q1-2016).

Earlier this month, the PMIs published by NBS and Caixin fell back moderately compared to their March levels. Still, divergence between the manufacturing and services PMIs remain strong. Annual export growth fell back in negative territory (-1.8% yoy), after a sharp positive outlier (11.5%) in March which was likely distorted by Lunar New Year issues. Imports fell deeper into negative territory again (-10.9% yoy), although remaining less negative than the average contraction seen in 2015. Import volumes continue to show some bottoming out as well. On a more positive note, deflationary pressures have continued to abate, with producer price inflation easing from -5.9% yoy in late 2015 to a 16-month low of -3.4% yoy in April. Meanwhile, CPI inflation has stabilised around 2.3% yoy in recent months, clearly higher than the average of 1.4% in 2015.

… although real estate sector still shows a clear pick-up

The softening of activity data is certainly not taking place in the real estate sector. By contrast, several property-sector related data have shown a sharp rebound in the first quarter of this year. Residential building floor space sold has for instance accelerated to a three-year high of around 40% yoy in April. Meanwhile, nationwide new house prices showed a 12th subsequent month of improvement in April, reaching the fastest pace of acceleration in two years. As we have indicated last month, the recovery of the property sector is strongly based on the stepping up of (fiscal) stimulus, while also reflecting the weak base of Q1-2015. The importance of stimulus is also reflectd in the fact that investment by state-related entities has accelerated sharply in Q1-2015 while private sector investment has slowed further to historic lows. This points to a crowding out of private investment, in itself not really a welcome structural development.

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Credit growth still outpaces nominal GDP growth …

After a sharp pick-up in Q1-2016, new lending slowed in April. Aggregate financing fell back to CNY 751 bn (March: CNY 2404 bn), while new yuan loans eased to CNY 556 bn (March: CNY 1370 bn). While this could be a first proof that Beijing is indeed changing its course and will put more focus into keeping lending in check, we should be careful with drawing hasty conclusions. Monthly lending data are notoriously volatile, with seasonal effects also playing a role (as April data typically fall compare to March). Moreover, social financing data do not take into account local government bond issuance, which surged in April. Taking that into account, total credit continued growing at around 16% yoy in April.

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… with rising overall credit a key risk surrounding China’s transition

As credit growth has outpaced nominal GDP growth in recent years, overall credit has risen to almost 250% of GDP in Q3-2015. The bulk of this (almost 70%, so around 170% of GDP) is outstanding to non-financial corporates. Household credit is accounting for around 15% (almost 40% of GDP). Also looking at the 2016 monetary targets announced in March this year (13% for social financing and M2), credit growth will likely continue to outpace nominal GDP growth this year. Hence, barring a radical policy tightening by Beijing, the overall credit to GDP ratio will likely rise further in the foreseeable future. As a result, according to Bloomberg estimates, the total debt service burden for Chinese corporates and households has been rising further, reaching 32% of GDP in Q1-2016.

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… but low external debt illustrates Beijing still has room to manoeuvre

The ongoing rise of China’s debt levels and the surrounding risks have been well-documented. This has also been a key factor explaining why Moody’s and S&P has recently put China on Negative outlook. The fact that China’s sovereign ratings remain high by EM standards partly relates to the fact that China’s external debt remains very low in an international perspective, both in terms of GDP and exports. This reflects that China’s has still a relatively closed capital account and the bulk of the debt of China Inc. is denominated in local currency, although this may change gradually now that the domestic bond market has been opened to foreign investors). Hence, in our view China’s debt overhang is particularly a domestic, longer-term issue. This certainly forms a future threat for the banking systemic and economic growth prospects if it is not managed adequately, but is unlikely to cause a externally driven liquidity crisis at short notice. Hence, although systemic credit risks at the macro level and credit risks of individual borrowers and NPLs at the meso level are rising, the authorities still have time to engineer a gradual and rather orderly deleveraging process going forward.

More attention to structural issues …,

Now that the authorities have succeeded in near-term economic stabilisation and risks surrounding China’s transition have come to the surface once more, Beijing will likely switch back the policy focus from demand management to addressing structural issues. This was also highlighted by an ‘unnamed authority’ in a leading newspaper earlier this month. In fact, the government has already started taking such structural measures, for instance aimed at reducing overcapacity (and jobs) in sectors such as heavy industry. However, we think Beijing will continue to pursue a gradual course and refrain from adopting a radical deleveraging, as that could form a threat to the growth target of 6.5-7% this year.

… although demand management will continue to play a role

We think that China’s fiscal policy will remain accommodative (we project the general budget deficit to rise further, from 3.5% of GDP in 2015 to 4% this ). The government’s recent announcement to invest CNY 7.4 trillion (around 6% of 2015 GDP) in infrastructure for the coming three years is indicative for this, although these measures do not necessary entail new initiatives. We have already explained before that Being has become more careful regarding the timing and form of monetary easing given uncertainties relating to the exchange rate and capital flows (also against the background of looming Fed rate hikes). In light of recent credit developments, we now expect one (in stead of two) additional 25 bp policy rate cut (to 4.10%) in late 2016 and still 100 bps in RRR cuts (to 16%) for the remainder of 2016. The authorities will likely also continue to use its special lending facilities, adjusting macroprudential regulation and take measures to ease debt service costs for heavily indebted corporates and local governments.