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Economic Insights

Among the concerns of global investors are China’s rising debt levels, an increase in bad loans, and troubled “zombie” state-owned companies.

 

In Brief

  • Financial markets have focused on China’s rising debt and its potential investment implications. Of particular concern is the increase in non-performing loans and the likelihood of higher defaults.
  • Also concerning is the economic and political environment in which these excesses have developed. For example, many of China’s state-owned enterprises (SOEs) are burdened with excessive debt.
  • Meanwhile, China’s banks are ill-prepared for even a small increase in defaults. 
  • What options does China have? Slow steps to address the problems of debt-ridden SOEs, combined with gradual recapitalization of banks, seems to be a likely approach. 
  • The key takeaway: A renewed emphasis on U.S.-focused assets may be appropriate while investors await signs of China’s recovery from its debt hangover.

 

Market concerns about China’s level of total debt have grown in recent months. The speed with which the nation’s debt has grown is more concerning still. But it is the increase in non-performing loans, and the likelihood of higher defaults, that ultimately could affect global growth and influence domestic and foreign asset classes worldwide. Analytical firms such as Wolfe Research conclude that China’s rising debt, slowing economic growth, and the subsequent consequences now represent the biggest threat to global markets owing to the ramifications of these fault lines. Billionaire investor George Soros, for example, sees fearful similarities between China’s debt-fueled economy and the conditions in the United States in 2007–08, just before the onset of the ensuing financial crisis that eviscerated world economies.

So, if there is one external factor that investors worldwide should be considering as they develop investment strategies, it is China’s debt dilemma.

China’s total government, private sector, and household debt quadrupled, from $7 trillion in 2007 to $28 trillion by mid-2014, according to McKinsey. Estimates of its debt-to-gross domestic product (GDP) ratio for 2015 range from 240% to 270%, far higher than the 175% average for emerging markets, based on data from the Bank for International Settlements. Meanwhile, new borrowing continues at an even faster pace, reaching nearly $1.0 trillion in first quarter 2016, which represents the biggest three-month surge on record, and more than 50% ahead of 2015’s pace, according to the Financial Times

Debt Reckoning
Over the past several years, China’s total debt has grown about twice as fast as its GDP. It appears that even that ratio is becoming worse. The Economist recently reported that “it now takes nearly four yuan of new borrowing to generate one yuan of additional GDP, up from just over one yuan of credit before the financial crisis [of 2008–09].”

More worrisome than the size of China’s debt and the speed with which it is growing is, we believe, the economic and political environment in which these excesses have developed. As China shifts from growth fueled by exports and investment to an economy driven by internal consumption and services, its economy is burdened with excessive debt among state-owned enterprises (SOEs).

Past growth of coal, steel, and cement SOEs was fueled by debt and supported by extensive infrastructure spending. The resulting overcapacity in these industries has pressured prices lower, and when combined with excessive debt burdens, has rendered many SOEs unprofitable and at risk of not meeting their debt-interest obligations. The Economist reports that in 2014 (according to the latest data available), 16% of the 1,000 biggest Chinese firms owed more in interest than they earned before tax. The situation is likely worse today as China’s transition away from infrastructure spending and export-driven growth reduces the revenue stream of heavily indebted SOEs. These so-called “zombie” companies may become even more unprofitable as the Chinese economy slows. 

Banks on the Brink?
Chinese regulators reported that for the first quarter of 2016, non-performing loans (NPLs) have increased for 18 consecutive quarters, reaching an 11-year high, at 1.75% of total loans. Private estimates are far higher. CLSA, a research-driven firm owned by China’s largest brokerage, estimates that NPLs could already be as high as 19% of loans outstanding, and could rise to 25%. Potential losses could amount to as much as $1.4 trillion, or 13.5% of China’s GDP. Similarly, an April 29 note from Macquarie, another research firm, cites the International Monetary Fund’s (IMF) conclusion that 20% of companies are at risk, with loans that could exceed $1.3 trillion.  

China’s banks are not prepared for even a small increase in defaults, let along an increase of the magnitude suggested by private analysts and the IMF. Reserves for non-performing loans are at minimal levels. According to Reuters, China bank regulators reported the loan-loss allowance ratio—a measure of cash set aside as a percentage of reported NPLs—declined in the first quarter of 2016, to 175%, a six-year low. Two of China’s four major banks reported levels below the regulatory threshold of 150%.

A slight increase in NPLs from the official level of 1.75% would demand an increase in banks’ cash reserves and a depletion of their capital. “To put things into perspective,” says Société Générale’s China economist, “a quarter of SOEs’ loans and bonds [i.e., the amount potentially at risk] are equivalent to the entire capital base of commercial banks plus their loan loss reserves.”

Seeking Solutions
What options does China have, then, to address these issues? Significant defaults are not the answer. Although widespread defaults of inefficient SOEs might allow elimination of overcapacity and more effective redeployment of resources, they would almost guarantee a bank crisis in China, stall economic growth, and promote political unrest. Additional lending to keep zombie companies alive seems a more acceptable solution, yet only creates a bigger problem later. 

Slow steps to address the problems of zombie companies, combined with gradual recapitalization of banks, seems to be a likely approach. Because the large banks and the SOEs are both owned by the government, solutions may be crafted differently than those constructed in capitalist democracies. Solutions include government payments to zombie companies for downsizing and for retraining and relocating displaced employees. Other solutions underway include debt-for-equity swaps, NPL securitization, and transfers of NPLs to a new state-owned asset management company, a so-called “bad” bank, a practice that China has embraced periodically.

Such solutions are not without difficulties. While they likely will involve some near-term pain, they do solve some issues, delay others and importantly, avoid placing China in a Twilight Zone of intractable economic and political difficulties.    

Investment Consequences
As China pursues resolution of its debt problems and reduction of overcapacity in segments of its economy, less of its resources will be available for renewed economic growth. A reduced reliance on debt to fuel growth also suggests a lower level of economic expansion from investment and associated consumption. In such an environment, commodities are likely to lose some of the support previously provided by Chinese demand. In addition, assuming China reduces overcapacity (no doubt with great reluctance), given the economic and political risks of reduced employment, continued supply of commodities such as steel, cement and coal should keep prices low, reducing their attractiveness to investors.

Meanwhile, emerging markets that rely on China as a market are not likely to rebound soon either. Accordingly, global inflation will not be pushed higher, and may instead face downward pressure, to the extent emerging markets reduce prices of commodity exports to expand sales. Slower emerging market growth, beginning with China, could increase investment flows to areas of reliable growth such as the United States, supporting U.S. dollar strength and possibly securities prices as well.

Finally, although China’s economy may slow, U.S. exports to China may remain largely unaffected. Only nine-tenths of 1.0% of U.S. GDP can be attributed to exports to China, according to the World Bank. And those exports include planes, movies, and advanced medical devices, items unlikely to be compromised because China’s commodity imports decline.

As bad debt in China becomes more visible, and as solutions to that problem unfold, the resulting slowdown could produce a number of investment effects, including weaker commodity prices, slower growth among select emerging markets, continued global deflationary pressures, U.S. dollar strength, and increased interest in U.S. securities that benefit from slow but persistent economic growth. An adverse direct impact on U.S. markets as a result of China’s debt problems is not apparent. As such, a renewed emphasis on U.S.-focused assets such as municipal bonds, corporate debt of U.S.-centric companies, and U.S. small- and mid-cap stocks may make sense as investors await signs of China’s recovery from its debt hangover.

 

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