The Delicate Act of Managing China’s Debt Load
Fixed Income Portfolio Manager Tom O’Mahony discusses Chinese authorities’ balancing act of curtailing debt issuance while maintaining economic growth.
- After years of issuing debt to fuel economic growth, Chinese authorities, recognizing the risks of excess leverage, took steps in 2017 to curtail borrowing.
- Recent moves may have gone too far as local and infrastructure investment has fallen precipitously, causing the government to begin loosening the reins on investment.
- A key concern among officials was a rapid economic slowdown sapping consumer confidence, thus impeding the country’s goal of transitioning to a consumption-based economy.
In the midst of the 10-year anniversary of the Global Financial Crisis (GFC), it has become something of a parlor game to identify potential sources of future systemic risk to global markets. A popular candidate is the level of debt recently accumulated in China. In assessing these concerns, we believe it is necessary to identify certain factors unique to the country’s economic structure that would influence any knock-on effects globally.
While China maintains a closed capital account – meaning the transmission mechanism to global markets is limited – a significant repricing of Chinese debt is a scenario investors should not overlook, given the potential impact it would have on global confidence and the real growth prospects of the country’s trading partners. Compounding these risks are concerns that Chinese authorities – in an attempt control the pace of credit expansion – may have tapped the brakes too aggressively, thus constricting economic growth. Lending credence to this concern are recent softer-than-expected data. Should authorities be unable to reverse course, China’s trading partners may be adversely affected as they could expect to see fewer orders in materials and capital goods from Chinese customers. While we see it as unlikely that a correction in Chinese debt markets would directly leak into global investment portfolios, and it is even less likely that an economic downturn would get away from policy makers, we believe both scenarios merit monitoring, especially – as proven by the GFC – the source of market tumult is often only clear after the fact.
Total Annual Chinese Bond Issuance
Chinese Debt Expansion: A Brief History
In the roughly 15 years preceding the GFC, China’s share of global investment more than tripled – from 5% to more than 15% – as the country modernized and its factories integrated into the global supply chain. In the wake of the crisis, authorities instituted countercyclical measures to support the broader economy as exports suffered from soft global demand. Investments in infrastructure, real estate and capital goods shot up and the country’s global share of investment now sits at more than 30%.
While these measures succeeded, they were not without unintended consequences. Foremost, increased investment ran counter to the government’s goal of shifting toward a consumer-driven economy. Also, much of the investment occurred at the provincial and local level and, thus, away from the direct purview of the central government. Revenue-hungry municipalities sold off land, which, in part, fueled a construction boom. Both private developers and municipal bond issuers found willing buyers for their debt, including, but not limited to, wealth management vehicles, lightly regulated components of the country’s shadow banking system. The result was China becoming the leading source – by a long shot – of global credit growth in the post-crisis years.
Tapping the Monetary Brakes…
A more assertive central government recognized the risk of unfettered credit expansion and, starting in 2016, attempted to tighten monetary conditions. Rising rates over the next two years slammed the door on money supply as broad monetary growth receded to under 10% annually. On the fiscal front, much was done to rein in the shadow banking sector, and federal authorities ordered municipalities to curtail aggressive, debt-fueled infrastructure spending. Beijing also has considerable influence over large state-owned banks and, accordingly, issued directives that when lending to state-owned enterprise (SOE) clients, a greater emphasis needs to be placed on risk management and gauging the long-term viability of debt-financed projects.
China Fixed Asset Investment
…But Hoping to Avoid a Skid
The tools implemented by authorities have proved to be blunt. While private sector fixed asset investment growth has stabilized, that of SOEs has slid into negative territory. Other industrial sector metrics, including production surveys, have also fallen considerably. The real concern to authorities, however, is negative sentiment leaching into the consumer sector. Led by a pronounced drop in car purchases, year-over-year retail sales growth in real terms has slipped toward 6%.
The Fulcrum of Employment
Negative consumer sentiment provides another headwind along the path toward a consumption-led economy. Potentially exacerbating the problem are indications of a weakening employment picture. While the official unemployment rate remains low, unemployment surveys have spiked over the course of 2018. The government tends to pay special attention to the jobs picture as it believes that rising unemployment could be a potential source of social discord, a development authorities seems eager to avoid.
In light of weakening data, policy makers have reversed course in an attempt to stimulate the economy. Recent statements by the People’s Bank of China (PBoC) continue to highlight the importance of deleveraging, but it has also lowered key reserve ratios. Other recently enacted stimulative measures include guiding deposit rates lower, expanding the breadth of collateral accepted by lenders and – specifically for small and medium enterprises – lowering financing costs and encouraging forbearances. On the local level, the authorities have implicitly been given the green light by Beijing to once again ramp up infrastructure spending.
Local Government Debt Issuance and Repo State
The balancing act undertaken by authorities indicates their awareness of the risks posed by excessive debt and a slowing economy. Given the country’s centralized power structure, we believe that the government’s recent proactive policy responses have a good chance of reducing the risk of more material adverse outcomes. Investors, however, still need to be mindful of developments in the world’s second-largest economy. In the event of a debt write-down, a closed capital account would likely insulate foreign investors from material losses.
A slowing economy, on the other hand, could weigh on the prospects of commodities exporters such as Chile, Brazil and Australia. Capital goods producers such as Japan, South Korea and Germany could see orders from Chinese factories drop. At highest risk would be emerging market companies and countries integrated into China’s supply chain that have recently increased their dollar-denominated debt load.
Should either scenario occur, the PBoC could consider allowing the value of the Renminbi to drift lower. While such a move would provide a tailwind for local exporters, it would run counter to authorities’ recent initiatives aimed at plugging the outflow of capital from the country, a step evidenced by the tamping down on cross-border M&A. A weaker Renminbi would also introduce another disinflationary force onto the global economy at a time when many central banks maintain a reflationary bias.
Foreign securities are subject to additional risks including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.