Possible Market Shocks
Possible shocks include policy missteps, liquidity crunch, investment slowdown and local government defaults
In the next 3-5 years, the Chinese economy will likely slow first before stabilizing in a range of 6-8% if reforms succeed. While a smooth transition is desirable, it’s not easy to achieve. The Chinese economy and market may face policy shocks, a liquidity crunch, a sharp investment slowdown, and local government defaults.
Policy shocks could come from forced reforms and policy lags
Policy shocks cannot be ruled out. If reforms are planned to tackle core issues in the economy, they may support market sentiment. But more likely than not reforms will be forced and thus may create some shocks to the economy and the market in the initial stages. While reform measures could be effective to address concerns on over-capacity, rising leverage ratios and credit dislocations, they may hurt growth momentum further before boosting it. The pace of reforms is thus critical. A summary of recent and future policy initiatives is in Figure 9.
- Growth-negative reforms: De-capacity, de-leveraging, tackling the credit dislocation problem (e.g., tightening activities in the shadow banking sector), interest rate and capital account liberalization, and SOE reforms, which are unlikely until SOEs lose money or credit is constrained.
- Growth-positive reforms: Abolishing the one-child policy, reforming the hukou system, monetizing the farmland, channeling credit to sectors with low leverage ratios (e.g., consumer-finance companies, privately-owned banks), fiscal reform and debt restructuring.
Policy consensus may not be achieved before it is too late. The government may favor de-leveraging and reforms, but further economic slowdown could trigger stimulus not a reform. Chinese policy-makers may have not prepared for an extended period of economic weakness and its unintended consequences, e.g., over-capacity, slow fiscal revenue growth, rising non-performing loans, and growing unemployment. More importantly, policy-makers are not always good at managing market expectations and communicating effectively with markets. In order to engineer a relatively smooth transition, China needs to improve decision-making and adopt a combination of cyclical and structural policy measures to address the short- and longer-term challenges. The cyclical policy is to mitigate the downside risk to the economy, while the structural measures are to create new growth drivers and improve the economic and market outlook.
Liquidity crunch would lead to a high risk premium for the economy, hurting the bond market
China could well be hit by another liquidity crunch if orderly changes to deleveraging do not take place in coming quarters. The liquidity risk would rise if China continues to rely on investment in the already leveraged sectors. Capital flight is possible if China’s capital-account liberalization overlaps with the Fed’s exit and a weak domestic economy. This may take place with RMB depreciation against the dollar. Another cause for panic could be NPLs slowing the economy.
The liquidity crunch since June shows that authorities are against speculation in the financial sector and warn of liquidity risk in the shadow banking sector. This would likely hurt key borrowers in the market, namely local governments and property developers. According to an estimate by a trust expert, about 40% of trust products (excluding those run through the banking sector) go to property developers, 20% to local governments, 20% to industrial and commercial activities, and 20% to bill financing, art collection and so on. The bond markets and lending activities will likely slow or shut down before money-market rates normalize. Due to the liquidity squeeze, bond issuance has dropped to Rmb543.9bn, almost half of Rmb921.2bn in May. (Figure 11).
Investment growth could drop to a single digit and GDP to 6%
Investment slowdown could be dramatic once de-leveraging begins. High moneymarket rates can force de-leveraging but at the cost of growth. Based on global trends, investment growth tends to fall off the cliff when the investment-GDP ratio peaks (Figure 12). In the US and Japan, investment growth rates fell by more than half, while in Korea, Taiwan and Thailand, it dropped by around 1/3 to half the first 5 years after the ratio peaked.
In China, the peak is near and there is a good chance of the investment growth rate halving in the coming five years, i.e. a drop to around 10%. This could slow GDP growth rates by around 2ppts, to around 6%. The government has initiated a new policy to open up the financial sector to consumer-finance companies and privately owned banks. This is an attempt to channel credit to the private and consumer sectors, which have lower leverage ratios. But results will take time to show up.
Risk of local government defaults, and thus NPLs could rise
Local government defaults are likely to drive up NPLs in the banking sector, so will the leveraged property developers. As the economy slows, the gap between government revenue and spending will widen (Figure 13). Revenue to the central government was flattish in the first 5 months of this year. If it continues, this will likely affect the fiscal transfer by the central government. It would add more pressure on the non-coastal areas whose spending power depends on central government transfer.
In 2012, the share of fiscal transfer as a percentage of local revenue was 26% for coastal areas, 34% for central China and 40% for the west provinces. Liquidity crunch and possible interest-rate liberalization would also increase the cost of local government borrowings and thus increase the risk of defaults. The central government may bail out some of those debts and local governments will have to use securitization and be forced to liquidate some of its assets. NPLs may rise because of 1) defaults by local governments and property developers, 2) SME defaults due to an export slowdown, and 3) de-capacity and deleveraging (Figure 14).
