When I lived in Hong Kong in the 1990s, Asia was a place of great mood swings. Today is no exception, with pessimism fast on the rise, as I observed during a recent trip to the region. What a leading shipping magnate told me about sums it up: “There’s no fun anymore.” China’s debt-driven growth model is on the skids. An economic slowdown, a freezing up in trade and plunging markets and currencies are casting a shadow across Asia—and the globe. How worried should the developed world be? First, a little perspective. China’s slowing economic activity has been with us for some time—and is reflected in falling commodity prices and China-exposed equities. See the chart below. What’s new is global markets’ intensifying focus on China, enhanced by the U.S. Federal Reserve’s recent emphasis on Asia weakness.
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Known Unknowns
Everybody knows China has a debt problem. The hard part is getting a read on the size and distribution of the liabilities. Below are some key numbers, sourced from UBS:
- Total debt (excluding the central government) stands at 210 percent of gross domestic product (GDP), yet the headline figure is misleading. The bulk of this debt is issued by state-owned enterprises and local government financing vehicles.
- Non-performing loans (NPLs) in China stand at just 1.5 percent of GDP. Yet this low number disguises a number of fault lines. Recorded NPLs are rising at 30 percent to 45 percent per annum. Loans deemed overdue but not yet impaired doubled this year—a sign of negative corporate cash flows and further debt troubles ahead.
- The official numbers don’t include the biggest problem area: off-balance-sheet loans. Banks don’t hold capital buffers against these loans; instead, they treat them as investments. Total bad debts in the system amount to around 11 percent of GDP, UBS estimates.
- The problems are mostly concentrated in a few sectors saddled by overcapacity and changing regulations, such as stricter pollution controls. Infrastructure (22 percent of bank assets), manufacturing (16 percent) and real estate (at a likely understated 7 percent) are the main offenders. Caveat: Debt in these sectors is likely worse than it appears. The official numbers only cover the on-balance-sheet exposures of 70 banks.
In short, credit risks in China are rising. So will China crash? Unlikely. Households have healthy balance sheets (bank deposits are 50 percent of household assets, according to DSG Asia), and China still has the world’s largest stash of foreign exchange reserves, according to data accessible via Bloomberg. To be sure, China’s currency reserves have shrunk by $400 billion over the past year, official data show. Yet talk of panic capital flight from China is a red herring, in my view. The decreasing reserves mostly reflect the rising U.S. dollar (which shrinks the value of non-dollar reserves) and a switch by some onshore Chinese corporates to yuan financing rather than U.S. dollar financing (a welcome trend).
Financial Sluggishness
The real problem: China is suffering a case of financial constipation. Crimped profits and rising overdue loans are pressuring the ability of the banking sector to allocate capital to where it’s needed most. The majority of credit is being funneled into deadbeat borrowers refinancing their loans—not to the growth businesses of the future. Debt service costs have risen to 15 percent of GDP—just short of record highs—according to CLSA. Interest rate cuts are holding this ratio down. Yet more and more credit is required to keep up growth. This suggests monetary policy is losing its potency. Will fiscal policy come to the rescue? More stimulus such as infrastructure spending could boost nominal GDP by up to 2.5 percent over the next two years, I estimate. Yet the effect could be muted given a reliance on local governments to implement spending plans. The intensifying anti-corruption purge and arrests of prominent finance executives after the recent stock market crash have instilled fear in local government officials. The result could be policy paralysis.
Recapturing the Spirit of Optimism
But even the doomsday crowd in Hong Kong recognizes two bright spots:
- MSCI’s inclusion of 14 Chinese firms listed in the U.S. (via American depository receipts, or ADRs), including the e-commerce behemoth Alibaba, in global indices from November.
- The potential for a deal by mid-2016 on the Trans-Pacific Partnership trade agreement (this would exclude China but buoy Asian trade over time).
So, how do we recapture the spirit of optimism in Asia? Tackling China’s bad debt–recognizing how much, who owns it and how to restructure it–is the key. The trouble is this will take some time. Ewen Cameron Watt, based in London and a contributor to the BlackRock Blog, is Chief Investment Strategist for BlackRock and the BlackRock Investment Institute.
