Significant restructuring and rebalancing of China’s underperforming economy is needed before the country sneezes and we all catch a cold.
China’s economy, long a reliable source of growth, has been experiencing a wave of economic difficulties that has created uncertainty in global markets. Although the economy continues to grow at a relatively stronger rate than the international standard, the deteriorating rate of an average of 10 percent between 2000 and 2010, to 6.7 percent as of year-end 2015 is substantial.
This has led to a somewhat cyclical deterioration across many sectors; from an over-leveraged corporate sector to a weakening commodity sector. As such, there are several problems dogging China’s economy and banking system that require urgent attention.
Although the Chinese economy’s overall growth rate stands at 6.7 percent as of year-end 2015, which is high by global standards, in reality, China’s story is no longer related to its growth rate, but rather to the extent in the government’s ability to maintain it. China’s economy has slowed gradually since 2010, when GDP grew by more than 10 percent. The economy is seen growing by 6.3 percent in 2016 by the International Monetary Fund (versus 8 percent for 2012 and 7.4 percent for 2014). Among the reasons for the decline in the growth rate are fiscal consolidation, a rise in household debt, and a contraction of the export-driven tradable sector. Moreover, with weak growth in Europe and Japan, moderate growth in the United States, and challenges among other developing countries, China’s trade sector is losing steam. In September 2016, an early warning of financial overheating by the Bank for International Settlements, which underscored the gap between credit and GDP, hit 30.1. Any level above 10 suggests that a crisis will occur “in any of the three years ahead,” the bank said. Policymakers have been implementing different tools to support growth in the short-term. That’s why some analysts expect only a moderate slowdown over the next few months.
Then there’s real estate. The sector comprises 25 percent of the economy’s GDP and it includes important ties to its economic sectors. More specifically, home prices in China’s four major cities jumped the most since 2012, with an average rise of 17 percent year-on-year. Thus, it can be determined that the main problem with this sector is overcapacity; developers have slowed their pace of construction as they struggle with growing inventories of unsold properties. Despite a loosening of mortgage and purchase controls, demand remains low.
Economists at Australia and New Zealand Banking Group recently estimated that it would take four years for developers to sell their existing property stocks at the current rate of investment. Even with affordable housing construction, it remains behind the recent rebound in property starts. To help combat this, the government has been more stringent in its regulation of the housing market, including the expansion of the property tax and allowing for decreasing delays to help stabilize market expectations. The uncertainties in the Chinese housing market have contributed to the spreading of bond defaults, as authorities in one city froze transactions related to multiple developers’ properties and a second moved to freeze a troubled company’s apartments. Moreover, due to the oversupply of properties, the volatility in housing prices, and the continued rise of household debt, smaller Chinese cities face a sharp correction and a deterioration in their financial health.
Commodity prices have also been on a downward trend since 2011, consequently accounting for the the worst performing asset class of 2015, reaching less than half the levels of the past four years. Given that China is the world’s largest commodity producer, its deteriorating economy still weighs on the commodity sector. For example, commodities (mostly metals) are used as collateral for loans and are falsified trades. This has been leading to high likelihoods of default or irregularities on banks’ balance sheets.
According to the IMF, China is expected to run a moderate budget deficit of 3 percent of GDP in 2016, with a manageable debt load equal to 46.8 percent of the economy, ranking it 100 out of 184 countries. On the surface, then, it appears well-placed to manage any slowdown. However, the number is based only on the central government’s debt, not on a provincial and municipal level. Since more than 80 percent of public spending in China comes from local governments, which are neither properly or transparently regulated nor necessarily guaranteed, that this could result in a large omission and an actual approximate debt-to-GDP ratio of over 280 percent.
An examination by China’s National Audit Office found that in 2013, outstanding debt was 18 trillion yuan, which had already exceeded the 2015 statutory limit. Banking risk is particularly more precarious than economic risk when it comes to the case of China, which is likely due to the fact that growth remains highly dependent on credit that’s mainly deriving from banks; China’s banking system assets represent more than 250 percent of GDP as of June 2016.
The IMF last year estimated a total fiscal deficit of 10 percent of GDP, while Goldman Sachs expected it at about 15 percent. Those numbers suggest a total deficit level on par with the United States during the 2008 financial crisis.
Nonperforming loans are on the rise—owing largely to the weaknesses in heavy industries, the commodity sector and the housing sector. While the official NPL ratio stands at 1.75 percent, rating agencies estimate the figure to be between 5 to 8 percent, while the IMF estimates it at a whopping 15 percent. If so, the banking sector and the wider economy could suffer considerably.
Chinese banks have attempted heavy write-offs in recent years, which is a positive step forward. However, the more the bad loans pile up, the more resources banks will need to set aside in provisions, leaving little additional capital for growth and ultimately, survival.
As for banks’ earnings, regulators have pushed lenders to get out of high-yield investments that were recorded off their balance sheets. Although this was a positive move to avoid a rise in shadow banking, banks were left to be more reliant on low-risk mortgages that generate relatively small profits. Moreover, banks have not seen a growing trend in their net interest margin (large source of revenue to banks) due to the six cuts to the benchmark interest rates by the PBOC since 2012. As a result, banks have been seeing a much slower growth in their bottom line results than previous years.
One of the largest, but least visible, problems is the shadow banking system. These banks deal with a broad range of non-guaranteed financial items such as trust and wealth management products (WMPs) to off-balance. This is done so that banks can report higher capital adequacy ratios and set aside less provision against bad loans (with naturally-reported low NPLs as a result).
In 2015, the shadow banking sector represented approximately 34 percent of total banking sector loans and 44 percent of GDP, with the off-balance products growing at more than 50 percent on an annual basis. Following years of growth to such an astounding number, the shadow banking industry is now experiencing a sharp slowdown after Beijing tightened its grip on the sector.
Despite government efforts, defaults have become more frequent following the surge in shadow banking activity and the slowdown in the economy. Loan defaults jumped by 43 percent in 2015 and 73 percent between 2014 and the start of 2016. Most defaults are recorded through the industrial sector. In addition to failing companies, very small domestic banks are merging to avoid failures given the banking system’s overexposure to the corporate sector.
Although many defaults have been taking place for a few years now, disclosure of defaults has become more transparent with the weakening of the economy. In the past, the central government guaranteed to prevent defaults from occurring so as to stabilize investor sentiment. However, since 2013, the government has taken on the proper methods to avoid long-term default by reducing moral hazard. As a result of the slowdown in the economy, this greatly limited these institutions from participating strongly in the market.
The Chinese government, led by President Xi Jinping, is in the center of a comprehensive anti-corruption/ anti-graft campaign that has led to hundreds of arrests of officials across the political and economic sectors of China. Since Xi came to power, at least 80 officials at provincial have stepped down after being charged with corruption. Of these, 59 are from provincial-level governments. The remaining ones are from central government bureaus or the military. Despite this reform effort, there continues to be corruption in conjunction with low transparency, bribery, and embezzlement, among others.
China’s data agencies also fall short on transparency, such as the National Bureau of Statistics (NBS). It provides hardly any information about source date or statistical framework, which makes it more challenging for outside verification.
I could list several examples of the lack of transparency in the economy, but one of the best is how fraudulent events are often used to artificially boost exports by way of fake trade accounting. Companies create artificial trade invoices that are not backed by an actual exchange of goods or services. Banks then facilitate the increase in transit trade financing and fake trade deals by failing to fulfill the responsibility of authenticity checks, while offering services of transit trade financing and receipt and payment.
Should any further deterioration occur in the Chinese economy, the pain is also likely to be felt elsewhere. As they say, when China sneezes, the world catches a cold. In January 2016, for example, stock markets around the world plummeted, largely due to fears of the direction the Chinese economy will go. This was triggered by an 11 percent decline on the Shanghai Stock Exchange and a devaluation in the renminbi.
China has persistently promised to take measures to limit the rapid growth of corporate debt, overhaul state-owned enterprises, and maintain a more stable growth rate. Following the credit crunch of June 2013, government officials initiated the Third Plenum to set policies regarding the economy, banking system, environment and other issues by increasing the role of the markets and decreasing the role of the government in economic activity. So far, the policies that have been adopted have only had mild success.
Despite the government’s efforts, China’s economic decline is likely to persist. The reality is that China’s transition to a consumer-driven economy is well underway and moderate growth can reasonably be expected in the medium-term—that is, unless the financial system’s problems intensify, in which case the government will need to participate in a fiscal stimulus through public spending projects to boost domestic demand for China’s goods.