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Economic Insights

China is engaged in a tricky balancing act as it seeks to strengthen its financial system while maintaining its recent pace of economic expansion.

 

In Brief

  • China is in the midst of a plan to transform its economy from one based on government investment into one based on consumption, but given the massive build-up in debt over the past 10 years, the government also needs to reduce the amount of leverage in the economy.
  • China recently implemented a deleveraging program consisting of tighter macro prudential policy, restraints on shadow banking, reduction of corporate debt, and controls on local government borrowing.
  • Given this deleveraging, tariffs imposed by the United States are likely to slow GDP growth further, so we believe China will temper the program and initiate additional stimulus in order to keep its pace of economic growth at 6%-plus.
  • Additional stimulus will consist of monetary easing, fiscal spending, tax cuts, and a modest depreciation of the yuan.

 

After four decades of rapid economic growth, China has arrived at a critical turning point. In 2016, the country initiated a plan to transform the economy from one based on exports and infrastructure development to one based on consumption. The success or failure of this pivot is likely to affect China’s trajectory for at least the next few decades.  

But China faces another challenge: its debt burden has become unsustainable. As a result of the stimulus implemented to counter the global financial crisis of 2008-09 the build-up of debt over the past decade has necessitated a deleveraging strategy, launched in 2016. Given that China’s economy has been fueled by debt since the financial crisis, deleveraging is likely to slow China’s rate of economic growth.

Complicating this deleveraging effort further is the decision of the Trump administration to address issues of intellectual property and trade imbalances by raising tariffs on Chinese imports, which is also likely to slow growth. China will now have to recalibrate its deleveraging policies to take the impact of tariffs into consideration. Maintaining a rate of growth of 6%-plus will also require additional monetary and fiscal stimulus.

This paper will outline the pillars of China’s deleveraging policy and assess how the trade impasse will affect the grand bargain that China is making between deleveraging and growth.

China’s Debt Surge and the Policy Response

China’s rapid growth since the global financial crisis has been fueled by a significant debt build-up. The accumulation of debt has been one of the largest in modern history, with current estimates placing it at 242% of China’s gross domestic product (GDP), up from just over 150% in 2008.1

Much of the debt accumulation has occurred among state-owned enterprises (SOE), which enjoy an implicit government guarantee and therefore attract financing more easily. Local governments, which often operate SOEs, have also accounted for much of the growth in debt. The banking sector, with its sale of wealth management products (WMP) and off-balance sheet shadow lending, has added to the systemic risk in the financial system as well.

 

Chart 1. The Growth of China’s Debt Burden Accelerated after the Global Financial Crisis

Source: International Monetary Fund.

 

The rapid growth of debt has made questions of sustainability and potential financial crisis unavoidable. Chinese policymakers have begun to address these questions, and in the second half of 2016, they introduced a deleveraging plan.

The deleveraging process has four pillars: 1) new macro prudential regulations for the banking sector, 2) better regulation of shadow banking activities, 3) reducing corporate leverage, and 4) greater control over local government financing.

1.  New Macro Prudential Policies

In 2016-17, the People’s Bank of China (PBOC) ramped up efforts to control financial risks with the launch of the Macro Prudential Assessment (MPA). The MPA was designed to monitor banks’ capital adequacy and liquidity. It also involved bringing off-balance sheet debt onto the books. These efforts had the effect of making credit less available, which raised market rates. In addition, the PBOC raised short-term rates in the fourth quarter of 2016, further tightening monetary policy.

 

Chart 2. 

Source: WIND. (05/23/2016-10/23/2018)

 

2. Increased Regulation of Shadow Banking

The deleveraging effort recognizes that much of the risk in China’s financial system resides in the shadow banking sector, which has grown from almost nothing a decade ago to between 50 and 90 trillion yuan, or between $7.8 trillion and $14 trillion.2 This growth was fueled by the sale of wealth management products (WMP), the proceeds of which banks used to make off-balance sheet loans to risky sectors of the economy. But rules put in place in 2016 have clamped down on the sale of these WMPs, and in 2017 sales flattened for the first time in a decade. Credit market conditions also tightened as rates moved up, and loan issuance dropped.

 

Chart 3. The Growth of Wealth Management Products Has Declined
(12/31/201412/31/2017)

Source: WIND.

 

As Chart 4 indicates, shadow banking’s share of total social financing (TSF), that is, total non-financial leverage, has dropped dramatically since December 2017, reducing China’s macro and financial risk.

 

Chart 4. Shadow Banking Now Contributes Less to the Growth of Total Social Financing
(01/01/201708/31/2018)

Source: WIND.

 

The government has also established the Financial Stability and Development Committee (FSDC) to oversee monetary, fiscal, and industrial development policies. Among the FSDC’s responsibilities is the prevention of a build-up of risks to the financial system.

3. Corporate Deleveraging

Deleveraging in the corporate sector is part of a broader effort known as Supply Side Structural Reform (SSSR), which is aimed at reducing that sector’s excess capacity.3 Corporate debt stood at 65% of the country’s total debt as of September 2016, or about 166% of GDP, according to the Bank for International Settlements. State-owned enterprises (SOEs) accounted for the bulk of this, about 70%.4

The need to deleverage has long been evident in certain industries, such as coal and steel.5 More work remains to be done, however. Debt to asset ratios for SOEs generally stood at 64.9% as of third quarter 2018, much higher than the ratios for large private companies and small and medium enterprises (SME), 55% and 37%, respectively. The goal for SOEs is to lower their ratios to 63.7% by 2020.6

 

Chart 5. Debt to Asset Ratios for SOEs Have Declined
(March 2015–October 2018)

Source: WIND.

 

4. Greater Control of Local Government Debt

While progress has been made in cutting back corporate debt and in reining in shadow banking, local government debt continues to be worrisome. Reducing this debt is made more difficult because much of it is hidden in off-balance sheet local government financing vehicles (LGFV). S&P Global Ratings believes that this off-balance sheet debt could be much larger than the amounts that have been publicly disclosed and could total as much as $6.0 trillion.7 Much of this debt has been raised to finance infrastructure development.

 

Chart 6. Local Government Debt Issuance Has Continued Despite Increased Scrutiny

Source: WIND.

 

Local government debt has also risen as a result of public-private partnerships (PPP). Local governments have been encouraged to employ PPPs as a means of funding infrastructure as these were seen as a way to reduce debt financing and replace it with equity financing. But many local governments have sold their shares to private parties, often SOEs, and promised certain returns—in effect converting these arrangements into debt financing. In some cases, LGFVs have signed these buy-back agreements on behalf of local governments, further raising LGFV debt burdens. The government has since placed additional restrictions on SOE participation in these PPP projects. As a result of restrictions on LGFV debt raising and reduced local government bond issuance, there has been a significant weakening in infrastructure investment.

 

Chart 7. The Growth of Public-Private Partnerships Has Been Declining
(March 2017-August 2018)

Source: WIND.

 

The Grand Bargain: Slow Deleveraging to Offset the Growth Slowdown

We estimate that the tariffs proposed by President Trump would result in a hit to China’s GDP growth next year of 50 basis points (bps), assuming no policy response. We believe, however, that China’s policymakers will respond with a set of measures designed to minimize this impact. Policymakers will not abandon the deleveraging program but will temper it in an effort to maintain an economic growth rate of around 6%. These measures are likely to include coordinated easing of monetary, fiscal, and regulatory policies. In addition, we expect some carefully controlled depreciation of the yuan. In the near-term, we anticipate a modest rebound in credit growth and a less dramatic unwinding of shadow credit.

Monetary Policy

In October 2018, the PBOC announced another cut in the reserve requirement ratio (RRR), and so far this year, RRR cuts and open market operations have injected RMB3.4 trillion into the banking system. In monetary terms, the latest cut in the RRR takes China’s liquidity injections this year to about 2.1% of GDP year to date. Combined with net capital inflows in the first half of the year, this has eased monetary policy conditions considerably. The effects of these measures will require a few quarters before they appear in headline data, but we expect an initial economic stabilization in the fourth quarter, with real improvement over the following two quarters.

Fiscal Policy

In addition to a more proactive monetary policy, we believe China’s fiscal policy will also become more expansionary. Tax cuts and export tax rebates have already exceeded the July 2018 forecast, and the fiscal deficit could rise to around 2.9%, above the 2.6% deficit targeted early this year. In 2019, cuts in income tax for households and for the corporate sector, along with a reduction in the value added tax are likely to continue to play an important role.

Continued investment in infrastructure is likely over the short term, while fixed asset investment in the manufacturing sector may slow, given a recent slowing in profits and in corporate borrowing. Tax cuts and other policies to support the private sector may provide some assistance, however.

Currency Policy

The October cut in the RRR and the lower fixing that ensued led the yuan to drop below the 6.9 level versus the dollar. While many observers expect the PBOC to launch a serious defense of the currency to prevent it from depreciating through the symbolically important 7.0 threshold and stave off further U.S. accusations of currency manipulation, we believe that support for the yuan is unlikely. Support would drastically curtail the PBOC’s capacity to further ease monetary policy and reduce domestic interest rates.

We believe, therefore, that the yuan will come under additional pressure and is likely to move through the 7.0 level. Not only does the PBOC need to continue with monetary easing, but it also lacks the incentive to defend the currency aggressively, as the prospects for near-term rapprochement with the United States remain bleak.

U.S.-China Tensions Likely to Persist

While investors are right to regard the current state of the U.S.-China relationship with concern, broader rifts have emerged that extend far beyond the trade imbalance. Fault lines range from enhanced screening of Chinese investments in the United States to military flashpoints in the South China Sea and the public disclosure of industrial espionage allegations leveled against a detained Chinese spy.

Although President Trump and President Xi Jinping agreed to a 90-day truce at the G-20 meeting, it appears unlikely that differences between China and the United States will be resolved easily. While tariffs were a readily available and highly visible tool for realigning the relationship, new measures being developed by Washington will focus on longer-term strategic considerations and will make tariffs a less relevant means of pressuring Beijing in the future.

 

1 International Monetary Fund, Article IV Consultation, July  2018.
2 “China’s tighter regulation of shadow banks begins to bite,” The Economist, June 14, 2018.
3 China’s supply side structural reforms: Progress and outlook, The Economist Intelligence Unit, 2017.
4 Ibid.
5 Haixu Qiu, China Reality Research, Financial deleveraging: Review and outlook, November 26, 2018.
6 Ibid.
7 “China’s Hidden Sub-national Debts Suggest More Defaults Are Likely,” S&P Global Ratings, October 15, 2018.

 

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward looking statements will materialize or that actual returns or results will not be materially different from those described here.

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