The market is always in search of a story and its corresponding trade idea. Unfortunately, so far this year, the US, Eurozone and Japan have been rather uncooperative on this matter as their respective central banks and economies stick to prior trends. As a result, investors have turned to China in the hope of securing this year’s performance.
Yu Yongding
Indeed, the economic challenges facing China in 2014 are very serious. Since 2010, China’s growth performance has been consistently disappointing. The growth rate has fallen from 10.4 percent in 2010 to 7.7 percent in 2013. The most recent economic statistics show that the economy is still heading south. More ominously, the black clouds of debt seem to thicken inexorably. The high-profile corporate bond default in March, the first in many years, sent a chill through markets in the spring. Many also thought the sharp weakening of the renminbi was an ominous sign.
China’s slowdown and financial risks have led to a wave of pessimism and potential opportunity for the market: either a big ‘China short’ is coming, or risk appetite should anticipate a major fillip as authorities inevitably blink and reflate through credit and/or fiscal stimulus. In my view, there isn’t a big China trade coming in either direction: the economy may fall further, but it is unlikely that the fall will be so large that the government has to usher in a large stimulus package; the financial instability is true, but resources available for the government to ensure stability are still plentiful.
In the past thirty years, predictions on the crash of the Chinese economy have been made on numerous occasions. However, without exception, all these predictions have failed to materialize. No country can defy gravity, but China is too unique. Whether it will stumble into a crisis cannot be judged by simply referring to historical precedents and/or some universally applicable indicators. To have something to say about the Chinese economy, one must get into details and take into consideration as many offsetting factors as possible. Predictions are largely pointless given the underpinning assumptions will almost invariably need to change.
China experienced far worse financial difficulties in the later 1990s and early 2000s. In the 1990s, Chinese banks’ non-performing loans (NPL) were huge. According to Moody, the NPL ratio was 40 percent to 45 percent in 2001. Everybody thought that China would fall off a financial cliff. However, very quickly, half of NPLs were written off without a fuss, and the other half were taken off balance sheet, sold to government-funded Asset Management Companies (AMC) at par for gradual resolution. Instead of suffering a Japan-style financial crisis, the economy entered a decade-long period of extraordinary high growth.
When China’s Big Four (the four state-owned mega-banks) were preparing their IPOs in 2004, skepticism ran high. Critics said that the Big Four had already technically been bankrupt, because of low capital adequacy. Again, the government acted quickly by injecting capital from the country’s vast foreign exchange reserves to the Big Four. Overnight, the Big Four’s capital adequacy ratio rose from 4-6 percent to above 8 percent. In the subsequent years, the IPOs were launched successfully and considered amongst the most resilient during the global financial crisis. Now they are ranked among the top 10 largest and most profitable banks in the world.
Currently, the bearish predictions of an imminent crisis in China are mostly based on the fact that China’s leverage ratio is too high. It is argued that developing countries that have had a credit boom nearly as big as China’s all end with a credit crisis and a major economic slowdown.
Yes, China’s debt-to-GDP ratio is very high, but so are the debt-to-GDP ratios in many successful East Asian economies, such as Taiwan, Singapore, Korea, Thailand and Malaysia. The difference is that China’s savings rate is much higher than most of them. Ceteris paribus, the higher the savings rate, the less likely a high debt-to-GDP ratio triggered financial crisis. In fact, China’s high debt-to-GDP ratio, to a large extent, is a result of China’s high savings rate vis-à-vis its equally high investment rate. Certainly, the inability to repay would contribute to the high debt-to-GDP ratio, but so far the nonperforming ratio for China’s major banks is still less than 1 percent. Hence, when talking about the danger of the high debt-to-GDP ratio in China, the danger must be discounted accordingly by taking into consideration its high savings rate and other specific factors. Of course, why the savings rate is so high is another matter, but it does not detract from the point that such a buffer exists.
If one accepts that China’s high debt-to-GDP ratio is indeed a great threat to its financial stability, then it should be noted that from a high debt-to-GDP ratio to a financial crisis, there are many links in between that need exploring. Only when all specific links have been identified, can one draw a tentative conclusion on whether a financial crisis is likely to happen.
A financial crisis and a banking crisis in particular, will happen only when the following three conditions apply simultaneously: a large fall in asset prices, a drying up of funding, and a depletion of equity capital. The Chinese government has yet to exhaust its policy capacity to work on all three fronts to prevent a financial crisis, due to its relatively strong fiscal position, large foreign exchange reserves, relative high economic growth and its effective control over the major banks.
The real estate bubble is commonly regarded as the single most important point of vulnerability in China’s financial system. Let’s assume the real estate bubble has burst. Will the price collapse bring down China’s banks? Probably not. In China, there are no subprime mortgages or special purpose vehicles (SPV) to obscure the nature of subprime mortgages – the required downpayment for mortgages can be as high as 50 percent (or even higher). Will house prices fall by more than 50 percent? Not very likely. When housing prices fall significantly, new buyers in big cities will enter the market and stabilize prices, and the country’s urbanization strategy will ensure that in these cities demographics support intrinsic demand. If necessary, the government may also enter the house market to buy unsold houses and use them for social purposes. Even if housing prices fall by more than 50 percent, commercial banks can still survive. First, the share of mortgages in commercial banks’ assets is about 20 percent for the country as a whole. Second, banks can recover funds by selling collateral. Last but not least, as a last resort, the government can step in like it did in the late 1990s and early 2000s to take NPLs off bank books.
How about the liability side of the commercial banks? The structural investment vehicles (SIVs) in the US played an important role in causing the subprime crisis. While there is a serious problem of maturity mismatch in China’s banking system, there are no such vehicles in China. Additionally, the severity of the mismatch is not as serious as some observers believe. In fact, the average term of deposits in China’s banks is about 9 months, while long-and-medium term credit accounts for just above half of total outstanding credit. Due to a lack of options, and the implicit guarantee by the government, there has never been a large-scale run on banks in China. After introducing a deposit insurance program, the possibility of a bank run will become even more remote.
China has a war chest of foreign exchange reserves that it finds difficult to dispense. When necessary, the Chinese government will not hesitate to inject capital from the reserves into commercial banks per past practice.
How about liquidity shortages and a credit crunch when commercial banks are facing a crisis situation? These sorts of problems should not happen either in China. All governors of the Big Four are ministers and members of Central Committee of the Communist Party. They will act swiftly to follow any instructions given by the government and party. Full stop.
However, there is one important caveat: China has to maintain its capital controls in the foreseeable future. If China were to lose control over its cross-border capital flows, a panic could break out so that capital outflows will turn into an avalanche and eventually bring down the whole financial system. This makes current plans to liberalize the capital account deeply troubling and inconsistent with other policy priorities.
While the view that China is inexorably heading for a financial crisis and economic crash should be dismissed, no one can deny that the Chinese economy is fraught with serious problems. China is now confronted with a fundamental contradiction. On one hand, due to the rampant “regulatory arbitrage”, China’s monetary interest rates have been rising steadily. One the other hand, the return of capital (ROC) in China has fallen rapidly since 2008, due to overinvestment and widespread misallocation of resources. According to Bai of Tsinghua University, in 2012, China’s ROC was 2.7 percent, while China’s benchmark interest rate on a one year loan was 6.7 percent. If the Chinese government fails to reverse this trend, a financial crisis of one form or another is inevitable at some point in the future.
Finally, the Chinese government should act quickly in response to social tensions. Reports of highly disruptive low-level bank runs and homeowners ransacking the offices of real estate companies to protest falling prices are deeply unsettling. If the government ‘blinks’ and responds with another massive and ill-conceived credit stimulus, instead of educating households about the concept of risk, the damage could be fatal.
For now, there is still no convincing evidence to show that China is facing an imminent financial crisis and an economic crash. Nonetheless, the Chinese government must realize that its margin for error in implementation is approaching its limits.
Yu Yongding is former President of the China Society of World Economics and Director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, and has also served on the Monetary Policy Committee of the People’s Bank of China.
