Should investors worry about China?
China’s success story has been impossible to ignore. For decades, the economy has grown at a blistering pace. But fears are growing that debts have hit dangerous levels.
For much of the last 20 years China has been the main engine powering the global economy.
China’s annual economic growth has averaged 9.82% since 1989; GDP growth peaked at 14.2% in 2007.
From demanding the raw materials needed to build its massive infrastructure projects such as housing, hospitals and highways, to delivering goods such as clothes, computers and cars that have sated the appetite of a consumer-hungry western world, China has been the epicentre of demand and supply.
Since the financial crisis it has been the last outpost for consistently high growth, albeit somewhat weaker in recent years. The economy grew by 6.9% last year, although this remains far stronger than 2.4% for the US or 2.3% for the UK.
China overtook Japan to become the world’s second largest economy in 2011. A range of forecasts have been offered on when it might overtake the US.
The Conference Board, a US research association, has predicted it could happen by 2018; PwC made a forecast of 2028. These targets assume that China’s success story continues.
Why are some investors worried?
The concern is that China’s banks have lent too much money and created too much supply in the economy that is not needed.
The country’s property market, perhaps, offers the most visible sign of this, with many homes and offices standing unsold and empty.
The chart below shows how debt has grown compared to the total size of the economy.
Earlier this month, the Bank for International Settlements (BIS) published data that suggested banks in China may face a crisis as a result of the surge in borrowing.
The BIS, often described as the central bank for central banks, measured the gap between credit and GDP, scoring China at 30.1 for the first quarter. Any level above 10 suggests a crisis might happen “in any of the three years ahead”. China’s score dwarfed the second highest of the countries assessed – Canada at 12.1.
Concerns have also been raised about the government’s reaction to slowing growth, with attempts made to replace falling investment from companies with state spending.
Confusing the picture for China is that it is an economy in transition. It is moving from being industrial, and export-led, to becoming more consumer-focused.
With this comes a natural decline in economic growth that has been exacerbated by the ongoing fallout from the global financial crisis in recent years.
What else is the government doing?
It has opened up financial markets and devalued the currency. It is unclear how much this has helped.
Recent analysis by the Emerging Market Debt team at Schroders scored risks for a range of countries.
It found that China was at greater risk of a crisis than it had been for 35 years, as the chart below shows.1
Will China face a crisis and what would it mean for world markets?
Views from the fund managers
Robin Parbook, Head of Asia ex Japan Equities at Schroders, said:
“We think little has changed in China, least of all our consistently held view over the last 5 years that Chinese banks, post the biggest credit bubble the world has even seen, are sitting on a mountain of bad debts that are likely to cost 30-50% of GDP to clear up.
“As the credit bubble gets bigger, the ever-greening of loans2 spread and become more dangerous; growth in WMP (wealth management products) issuance continues to explode as banks desperately try and get their toxic loans off-balance sheet.
“We are also cautious on the much vaunted economic rebalancing in China as the Government continues to try and boost the economy through state led intervention.
“However, although the risks are rising, at this stage we do not think China is imminently heading into a financial crisis.
“With the capital account effectively under much tighter control after the measures put in place earlier this year, a large current account surplus, high savings rate and massive FX reserves it is hard to see an imminent crisis in China.
“Instead we now expect China to follow a model similar to Japan in the 1990s where the economy is sluggish and deflation prone which leads to periodic Government fiscal stimulus packages and the rapid accumulation of Government debt.”
Abdallah Guezour, Head of Emerging Market Debt Absolute Return, said:
"China’s economic vulnerabilities have reached dangerous levels since 2012, judging by the Country Risk Scoring Model developed by Schroders’ Emerging Market Debt Absolute Return Team.
"The model shows that the country remains at risk of crisis because of an extremely overextended credit cycle. Put simply, there are increasing imbalances within the Chinese economy, an indication of which is the sharply increasing level of debt. In addition the Chinese currency has become significantly overvalued.
"By renewing efforts to stimulate the economy while tightening controls on the flow of capital out of the country, China’s leadership has delayed the required reducing of debt of the economy and shown a lack of serious commitment to structural reforms.
"Trying to grow money supply and maintain a stable currency isn’t possible. Based on historical precedents in other countries, this often forces a change in currency policy that leads to a large devaluation. China will ultimately be forced to make this choice.
"The good news is that the impact of the painful adjustments that China has been putting off has to a large degree already been reflected in a number of markets. This is particularly the case for emerging market currencies which have been devalued significantly in recent years."
Craig Botham, Emerging Markets Economist, said:
“Bank funding is largely stable and derived from household deposits (though reliance on interbank funding is growing), and strict capital controls trap funds in the system while also greatly limiting the entry of foreign money.
“Financial crises are typically triggered by a sudden stop of capital flows to the financial system. Given the composition of funding, we think this is very unlikely in the next six months. We would be less sanguine over the next three years.”
1. A country risk model is updated for all countries in our investment universe at the start of each quarter and whenever an individual country is reviewed. Countries are scored on a scale from -12 to +12 reflecting the country’s risk based on six key factors (growth dynamics, sovereign external liquidity, hot money indicator, banking system external liquidity, credit cycle and competitiveness), each of which is scored from -2 to +2.↩
2. Evergreen Loan: A loan that does not require the principal amount to be paid off within a specified period of time. ↩