We first raised the topic of the sustainability of China’s capex driven growth in a report we published in 2009 (“China’s Investment Boom: the Great Leap into Unknown”, August 2009). In that report we emphasized decreasing marginal returns on investment; the maturity of China’s investment cycle and analyzed its most important components. Our conclusion was that in a best case scenario, China’s economic growth would experience a slow-down sometime in H2 2010 which would lead to a global growth scare. We also warned that the postponement of transition from an investment-led/high growth economy to a consumption-driven/lower growth model would make the shift more painful and lead to a credit bust.
The focus of this report is on the balance sheet transformation of the Chinese economy that has occurred over the last three years in an attempt to postpone such a transition. There are three main reasons we believe that China is on the edge of a painful adjustment which we alluded to back in 2009:
Shadow banking pushing credit expansion to the edge of a crisis: China’s credit expansion is unprecedented in its pace and advanced in its extent. Complex mechanisms employed by borrowers and lenders in the unregulated shadow banking system create an inherent instability.
Real estate and infrastructure investment at a critical juncture: these two main destinations of credit flows are suffering from worsening fundamentals and are showing varying degrees of stress.
Interdependence in China’s financial system: excessive lending, wasteful infrastructure investing and speculation in the real estate market have become closely interrelated. This interdependence increases the vulnerability of the system and makes solving a future crisis complicated.
The upcoming credit bust in China will be of a magnitude that requires government intervention. Whilst the Chinese government has capacity to bail out its financial system it is going to mark an end of the investment-led growth model. This will not only lead to lower growth rates in China, but will be a major global event, given the world’s reliance on China’s “economic miracle”.
Rampant Credit Growth and Shadow Banking
In order to combat the slow-down induced by the 2008 financial crisis, Chinese authorities initiated the world’s most ambitious stimulus via bank lending. The strategy was ostensibly vindicated as Chinese GDP growth barely slowed in 2009. However, when Chinese authorities tried to rein in lending by initiating a cycle of deposit Reserve Requirement Ratio (RRR) hikes in February 2010, it led to a substantial correction in asset prices and became a threat to economic growth. Then, similarly to the US’s response to the Fed’s hiking cycle of 2004-06, the Chinese financial system circumvented monetary tightening through off-balance sheet “shadow-bank” credit expansion. This was achieved through a number of different schemes. The principal components of shadow-banking have become trust products, undiscounted bank acceptances and offshore lending, which all serve the purpose of evading regulation concerning leverage ratios, loan quotas and permitted types of loans. Inclusion of shadow
banking paints a much more precarious picture in terms of the size and the pace of credit expansion in China.
Fitch estimates1 that China’s total credit expansion for 2011 is on course to be as large as 38% of GDP, bringing credit to GDP ratio to 187% by year-end. From its trough in 2008 the credit to GDP ratio will have increased by a whopping 61%. Market observers are beginning to make comparisons between the credit situation in China and that of Japan in 1991 and of the US in 2008, something we have been highlighting for a while.
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