fast growth.
Rising funding cost, investment slowdown and pending reforms may drag down growth
The slowdown is driven by over-capacity, unsustainable debts, and credit dislocation. First, funding costs may rise as China is forced to de-leverage. The infrastructure and property sectors may face credit constraints and rising cost of capital after the recent liquidity shock. Second, over-capacity and credit dislocation have contributed to the investment slowdown. Third, unlike their predecessors, the new leaders are less likely to stimulate the economy. China’s future growth will likely depend on the pace of reform in general and de-leveraging in particular. However, it remains unclear how reforms would be rolled out in coming months; any lack of policy coordination among regulators and ministries could exacerbate the slowdown.
Pace of re-leveraging in the economy is unsustainable
The rapid debt expansion in the past cannot be replicated going forward. China’s non-financial (and non-government) debts increased from 115% of GDP in 2007 to 151% in 2012 (Figure 2). This is even worse if local government debts are included. Due to limited sources of funding, local governments rely heavily on new debt. Local government debts had been expanding in line with the growth rate of infrastructure investments (Figure 3). This raises a critical question about the debt expansion this year, as infrastructure investment is up 21% yoy.
According to Mr Liu Jiayi, Head of China’s Auditing Office, out of 36 audited provinces and provincial capitals, 4 provinces and 8 provincial capitals had debts growing more than 20% between 2010 and 2012. The fastest debt growth rate was 65%. This suggests that the debt control introduced by regulators last year was not effective. Also, 55% of debt payment was promised to be repaid by land sales in 4 provinces and 17 provincial capital cities in 2012, and the principal and interest payments in these regions were already about 1.25 times their disposable land sales revenues. In other words, if existing loans cannot be rolled over when due, these local governments would have already exhausted their funding and no new infrastructure projects would be funded.
More credit has been allocated to sectors that are already highly leveraged, i.e., local governments, inland China and SOEs
The misallocation of credit has further reduced efficient use of credit. More credit is allocated to highly leveraged local governments (vs. manufacturing), non-coastal areas (vs. coastal area), and large firms (vs. SMEs).
- Relative to manufacturing, local governments get more credit. Fixed-asset investment (FAI) is moderating in manufacturing, services and resources sectors (Figure 4). While property sector investment is relatively stable, the only sector that has growth accelerating is the infrastructure sector. In order to support FAI, local governments would have to lever up further from current levels.
- More credit is allocated to non-coastal areas. In 2012, the central and west provinces had loan growth about 5ppts faster than their peers in the coastal areas (Figure 5). This is partly driven by more infrastructure investment in inland China. Historically, inland China is more indebted than the coastal region.
- More credit has been allocated to SOEs. FAI by SMEs has dropped to the lowest level since 2007 and ditto for foreign funded enterprises (Figure 6). Meanwhile, investment by SOEs has continued to pick up since 2012. Among A-share listed non-financial enterprises, the debt-to-equity ratio is 87.3% for SOEs and 62.2% for non-SOEs.
Local governments, non-coastal areas and SOEs are sectors with relatively high leverage ratios. Compared with their benchmark sectors, one unit of credit allocated to these sectors produces less investment dollars and thus reduces the efficiency of credit allocation. China needs to exit the liquidity dilemma, i.e., deteriorating investment efficiency, requesting for more liquidity support, and thus further releveraging lifting the low-quality economic growth. Together with double-counting of financial data, this explains why loose money fails is unlikely to lift growth this year.
Loose liquidity conditions can no longer lift the economy
Amid an economic slowdown, commercial banks are hesitant to fund real economic activities. Instead, they do so through the shadow banking sector based on incorrect pricing of risk. The shadow banking sector has boomed partly because of regulated deposit rates and partly because of low risk premium in a market where defaults are prohibited. As a result, loans for FAI has been consistently weaker than overall loan growth since 2012 (Figure 7). Moreover, due to a margin squeeze, existing projects have been unable to expand in recent years and therefore the share of new projects in FAI has remained high since the overheating in 2007 (Figure 8).
China’s growth in coming years will be determined by the balance between growth and reform. In our view, 6% growth or so is more appropriate to maintain some unemployment pressure and thus trigger economic reform and painful rebalancing. But there is a limit to it as the unemployment rate may start to rise if the economy weakens further from 7% and the risk of PPI deflation spreads to consumer prices. To defend a higher level of growth will likely leave little room for reforms.
Chinese authorities want to defend 7% GDP growth, though 6% looks more appropriate
Our conversations with Chinese officials indicate that the government would still hope to defend 7% growth in coming years to avoid fast job market contraction. Some policy support is possible if the 7% growth rate is tested. The credit crunch recently exacerbated the downside risk to the economy. The bond market would stay shut before the Shibor normalizes. Infrastructure investments, the property sector and SMEs would be hurt if the Chinese authorities aim at clamping down shadow banking. So the PBOC would have to step in and maintain accommodative liquidity conditions for the rest of the year. This is why we believed that the high Shibor would be short-lived. The overnight Shibor fell to below 4% in the first week of July, back to its normal range of 2-4%.
Stimulus is still possible if the economy slows far below 7% yoy this year and next. Unlike the one introduced in Nov 2008, future stimulus would be enough to only defend 7% growth. Instruments exist to defend growth: 1) More infrastructure investment could be launched and funded by supportive monetary policy (including interest-rate cuts); 2) China could also stem rising NPLs by establishing some rescue facilities; 3) Debt restructuring through securitization; 4) More investment could be generated by opening up the infrastructure and services sectors to private investors.
