China’s economy has long relied on compressed interest rates in conjunction with strict capital controls and a tightly managed exchange rate. A new ADBI paper suggests, however, that modest liberalization and gradual internationalization of the renminbi since 2005 have lessened state control over financial parameters. Inconsistencies and risks of market dislocations have become more evident.
A new McKinsey report estimates that total debt of households, corporates, and governments has expanded 40% since 2007, reaching a total of 286% of GDP last year. Government debt ratios will be hard to contain through fiscal tightening and economic growth alone. China’s non-financial debt has quadrupled, with credit quality critically dependent on the real estate sector.
On aggregate, global financial leverage has further increased since the great financial crisis. Most worrisome is the declining debt service capacity of public and private borrowers due to falling potential GDP growth and inflation. This precarious development virtually enforces very low real interest rates. EM leverage has increased fastest in recent years. China in particular poses maybe the greatest global debt problem.
The IMF’s latest staff report on China serves as a reminder of key vulnerabilities. With repressed real interest rates corporate leverage remains high and particularly so in state-owned enterprises. Shadow banking has exceeded 50% of GDP and is still growing. Economic growth and credit quality are exposed to an unbalanced real estate sector. And the augmented fiscal deficit is already close to 7.5% of GDP, due mainly to local governments’ net borrowing through financing vehicles.
Nomura research has summarized evidence of oversupply of residential property in China. Urban floor space per capita is now estimated to be higher than in some developed countries. Land conversion is still rising, while urbanization is slowing. Potential triggers for a sharp correction include interest rate liberalization, capital outflows and property taxes. A plunge in property activity would have serious economic and financial consequences.
The IMF, like other institutions, estimates that China’s fiscal position is much weaker than suggested by headline statistics. A new paper sees the augmented fiscal debt at around to 45% of GDP and the augmented fiscal deficit at close to 10% of GDP. Financial stability risks arise from dependence on a favorable ratio of growth to real interest rates, the reliance of local budgets on real estate sales, and the refinancing of local government financing vehicles’ debt.
A Nomura research report suggests that China’s local government financing vehicles now pose a major risk for the economy. Their debt stock has surged close to 40% of GDP over the past three years. Profitability is poor, liquidity risks are high, and solvency hinges on government support.
A new Standard Chartered Research Report investigates pockets of potential credit risk in Asia, by using a new comprehensive set of metrics. China’s overleveraged corporates are at the forefront of concerns, as mentioned in other posts (view here). Japan’s massive 400% debt-to-GDP ratio is a potentially large risk if real interest rates in the country ever increase. India is burdened with a high government debt ratio and an apparently deteriorating profile of corporate debt.
Chinese commodity financing deals exemplify how regulation and circumvention can distort more than one major market. These transactions have been a means for circumventing capital controls and facilitated short USD-CNY carry trades. Thereby they generated capital inflows into China, and distorted demand for physical metals (particularly copper) vis-a-vis futures. As China’s State Administration of Foreign Exchange (SAFE) has issued new regulation to curb these transactions, rapid unwinding might cause reverse distortions.
Morgan Stanley’s Viktor Hjort, Nishant Sood, and Gaurav Singhal show that financial leverage of China’s corporates has reached record highs, particularly for state-owned enterprises (SOEs). Increased debt financing reflects easy credit conditions and has partly served to cover funding gaps. In case of an economic downturn, consequences for credit quality would probably be more severe now than back in 2009.
Macrosynergy is a London based macroeconomic research and technology company whose founders have developed and employed macro quantamental investment strategies in liquid, tradable asset classes, across many markets and for a variety of different factors to generate competitive, uncorrelated investment returns for institutional investors for two decades. Our quantitative-fundamental (quantamental) computing system tracks a broad range of real-time macroeconomic trends in developed and emerging countries, transforming them into macro systematic quantamental investment strategies. In June 2020 Macrosynergy and J.P. Morgan started a collaboration to scale the quantamental system and to popularize tradable economics across financial markets.
