China’s Debt Levels – Staying The Course by Kenneth Lowe, CFA – Matthews Asia
As an investor within Asian capital markets, the years since the turn of the decade can be most aptly described as volatile. “Volatility” has certainly become one of the most utilized phrases to explain the current zeitgeist of financial markets and, frustratingly, I can empathize with its overuse. For many of us looking at emerging markets, the proclamations of a vastly growing emerging middle class and GDP growth that is superior to our home market of the United States have struggled to provide investors with meaningful returns of late, and most certainly have provided its fair share of panic inducing drops. The peaks and valleys associated with our markets have not lessened with time and have given our clients an understandable reason to pause and ask themselves the question of whether they need to have such exposure.
For me, there are a few questions that are worth musing on. What is causing all of this volatility? Is it here to stay and how does it get resolved? But most importantly, can we find companies that cannot just weather this storm, but come out the other side of it even stronger?
The first of these is both easy but complex to weigh in on. A confluence of factors have influenced market moves over the last few years with highlights that include the divergence of U.S. monetary policy in relation to the rest of the world, a deflationary and weak aggregate demand backdrop in Europe, the introduction of negative interest rates and potentially dangerous and experimental monetary policy from central banks such as the Bank of Japan, not forgetting the outlandishly large debt levels that have been accumulated in China alongside a slowing domestic economy and instances of currency devaluation. This latter issue has also helped to drive the end of a commodity super cycle that lasted for most of the 2000s, and has caused many challenges for currencies and economies in those geographies with large exposure to the sector such as Brazil, Indonesia, Malaysia, Australia et al. I would also be remiss as an Asia investor to fail to mention the political changes in geographies such as India as having a powerful influence on sentiment.
This incomplete laundry list of issues has helped to shape a change in the multiples that investors are willing to pay for Asian markets. From a price-to-earnings (P/E) standpoint, the market has fluctuated from a high of around 13.6x earnings in April 2015 to a low of 10.8x earlier this year and about 12.1x at the time of writing. Although a change in valuations is often the largest driver of near-term market moves, we have also witnessed an above-normal change in the fundamentals of companies and their ability to deliver on earnings. We have talked before about the perennial overestimation of earnings growth within Asia, and this cycle has been particularly vicious with earnings estimates for 2016 having been cut by over 14% during the last couple of years. This has led to an environment where, despite Asia’s promise, earnings growth for the overall market is likely to be paltry in the near term.
It is less the sentiment-driven movement in market multiples that worries this investor, after all, we generally believe in the mantra that volatility is the opportunity generator for our strategies. However, it is indeed the downtrend in profitability for Asian corporations that is somewhat concerning. Returns on Equities (ROEs) have been in decline for over four years, partially due to an index composition that is too heavily weighted toward commodity sectors, but also partially due to top-line misses, overcapacity and a lack of sensible capital allocation policies in many areas. And this drop in ROEs is despite leverage ratios that have mushroomed across the region ever since the global financial crisis. Prior to 2008, debt levels across most of Asia were very manageable. This is true even for the country that has become the poster child for rapid rises in debt—China. In 2007, the nation had only US$7.4 trillion of debt, which was equivalent to approximately 158% of GDP—a number somewhat within the realms of sensible expectations. Fast forward to just mid-2014 and McKinsey estimates that Chinese debt has expanded by more than 120% of GDP and to around US$28 trillion in debt, or around 4x the quantity that existed previously. More recent estimates are obviously substantially higher, with January 2016 alone witnessing a rise of US$519 billion.
China’s Debt Levels
Now, an expansion should be partly expected (albeit we would hope it to be at a much slower pace) as many Asian countries such as China have high savings rates and therefore the necessary liquidity to allow some increase in credit. Further, we know that the level of financial deepening often moves in tandem with the development of an economy. But that does not mean that we shouldn’t be concerned. According to the IMF paper “Dealing with credit booms and busts,” in the aftermath of credit booms something “goes wrong” about two times out of three” in the over 170 cases that they examined. Further, Morgan Stanley claims that an economic slowdown followed all 30 of the most extreme credit binges since the 1980s. For China, some of the higher risk factors such as a weak current account, high external borrowings, and high inflation rates are not issues, but the pace of credit expansion, its longevity and the standards of bank supervision are worrying.
Of course, a strong government balance sheet does provide a much-needed cushion for China and there are levers for them to pull on. Policies that appear to be gaining traction are capital controls to ensure that liquidity remains plentiful, as well as rate cuts, a clamp down on non-bank lending, and debt-for-equity swaps. In more recent weeks, it also appears that the government may make another attempt at raising the level of the equity market in order to try to deleverage an economy that even China’s Central Bank Governor Zhou admitted had lending as a share of GDP as “too high.” Frustratingly, few of these can be regarded as the reform required to enhance the market’s role within the economy.
In truth, it remains likely that we’ll see plenty of volatility-inducing headlines about high Chinese debt levels for the foreseeable future until we get some form of resolution—deleveraging, a debt crisis or otherwise. Ultimately, much of the worrying corporate debt resides with the state-owned enterprise (SOE) companies that still make up about 30% of Chinese GDP. Despite the country’s many steps forward over the last 30 years, these businesses continue to enjoy greater access to funding alongside what are often cheaper financing costs. Although nonperforming loans within the country are nominally containable at 1.67% of total loans, many are aware that there appears to be a rolling over of loan maturities as well as credit being provided to pay off old debt and even operating costs—a practice that may well be hiding the “true” number as metrics, such as debt-to-operating cash flow, the lengthening of receivables days, and a rising incremental capital output ratio are worrying. With