China’s Loan Spike May Not Be A Red Flag by Hayden Briscoe & Anthony Chan, Alliance Bernstein
Lending in China has jumped massively, startling already rattled investors and intensifying fears that the country’s financial system could be close to collapse. While these concerns are understandable, we think they may be overdone and based on a too-simplistic assessment of the risks.
As investor sentiment toward China grew increasingly bearish in January, the People’s Bank of China (PBOC) worked hard to discourage capital outflows and the possibility that interest rates would have to rise to support the currency.
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It did so by injecting liquidity into the system. Because of this, investors naturally expected that government-lending figures for January would show some increase, reflecting the distribution of liquidity via banks into the real economy.
In the event, however, the increase was beyond all expectation. The flow of total social financing (TSF), the broadest measure of liquidity in China’s financial system, was RMB3.42 trillion (US$520 billion)—a 73% year-over-year increase (Display).
This set off alarm bells for many investors, who saw the blowout as evidence of the government’s desperation to underpin growth—a view apparently supported by the fact that growth in TSF stock continued to run at about 12%–13% year-over-year, or twice the 6%–7% year-over-year for nominal GDP expansion.
In principle, this was a more prudent way for China to let liquidity into its system than cutting the reserve ratio requirement for banks—a more structural and less flexible measure which the markets had been calling for since before Chinese New Year.
By all appearances, however, the PBOC overreacted and now needs to wind back some of the excess liquidity. We’re less certain, however, that investors are correct in thinking that the increase in lending implies a proportional increase in the risk of a systemic financial failure.
Such perceptions reflect a classic policy dilemma for the PBOC and the government as they attempt to steer the economy beyond its dependence on investment to a broader and more diversified model in which consumption plays a larger role.
When the PBOC uses its plentiful supply of liquidity to underpin domestic financial stability, some investors take comfort in the fact that it has the resources to take such action; others, as noted, see it negatively—as a reaction to growing pressure on the economy and financial system.
Still others interpret such actions to mean that China’s policymakers are re-leveraging the economy and stepping away from the reforms necessary to transition it to a more sustainable growth model.
Such ambiguity is perhaps to be expected in China’s case because, as a one-party state developing a more open and diversified economy, it must grapple with a range of complexities and contradictions.
In our view, these complexities may partly explain the size of the January increase in lending, and some understanding of them may help investors to develop a more appropriately nuanced appreciation of the risks and dynamics underlying the PBOC’s actions.
An Entrenched Relationship
Many investors who see the increase as a sign that China is re-leveraging its economy point to the fact that most of the acceleration was in medium- to long-term loans. Traditionally, growth in this type of credit has been a good leading indicator of a recovery in fixed-asset investments.
We think this is unlikely on this occasion for a number of reasons, including the continuing economic slowdown, the progressive move from an investment-driven economy to one in which consumption is more important, and the growing diversification of funding sources for Chinese corporates.
Another possible explanation may be that the increase in lending was in part seasonal—the result of companies wanting to secure loans at the beginning of the year and banks wanting to expand their loan books.
Also, local governments and state-owned enterprises (SOEs) have been under pressure from the central government to borrow and launch projects to support growth.
Again, however, we think these are unlikely or insufficient explanations, as they would account for only a fraction of the unusually large increase in lending.
Other factors must be in play, and we suspect that one of them may be the switch by Chinese companies from US-dollar debt to loans denominated in RMB, in anticipation of a protracted devaluation in the domestic currency. This would have a broadly neutral-to-positive effect on the economy and financial system.
Another could be that banks have been proactive in helping to prevent systemic default risk by extending more revolving credit facilities to unprofitable SEOs, a view backed by the combination of credit growth and the record fall in nominal GDP growth. Most of the industries outside the services sector are SOEs and have been sluggish for a long time, with little demand for credit.
The close and mutually supportive relationship between state companies and state banks has been entrenched for a very long time, and is one of the complexities that the PBOC and government need to address in their push for a more open economy; it is also, in our view, a highly plausible part-explanation for the sharp increase in January lending.
Seen from this perspective, the reasons for the increase in lending remain less transparent than we would like, but the range of possible explanations counsels against jumping to conclusions that China’s financial system is about to crash.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.