The year of the sheep has been anything but gentle and kind to the Chinese financial market. The year began with a lion’s roar as the A-share market soared into irrational euphoria. The sharp increase in prices was entirely driven by policy expectations and momentum trading, and without support from economic fundamentals. A-shares ultimately collapsed under the weight of its own contradiction as Chinese authorities reluctantly moved to drain liquidity from the system. The result was a poorly-conceived and an even more poorly-communicated A-share rescue plan that did little to inspire confidence among domestic and foreign investors alike. As the equity market debacle unravelled in August, investors were ambushed by a large and unexpected depreciation of the renminbi. Combined with accelerating capital outflows and a grinding halt to the old-industrial economy, the year that arrived ‘roaring like a lion’ is definitely announcing its departure as a timid lamb. With continual deterioration in China’s real economy, conditions may continue to worsen in the financial markets in the coming year of the monkey. Here are my five warning signs of further turbulence in the year to come.
- Rising non-preforming loans (NPL) ratio
Since 2012Q3, the NPL ratio in China has been on the rise from a low of 0.94% to a recent high of 1.59% in 2015Q3. A rising NPL ratio is expected as the Chinese economy slows and weaker firms would naturally default as their operations lose profitability. However, the worry in the China is that banks over-extended their lending during the stimulus response to the Global Finance Crisis. In 2009-2010, commercial banks in China lent generously to various local governments, real-estate and infrastructure projects that yield little economic value. As the Chinese economy slows, the burden of the debtor to service these loans increase, leading to widespread default in many parts of the weak industrial sector. However, despite the many signs of widespread weakness in China’s industrial sector, the NPL ratio remains surprising low compared to international peers and even in sectors that have shown severe contraction in profit and revenue (i.e. mining, construction and real-estate). The remarkably stable nature of the NPL ratio in the Chinese banking system is likely smoothed out by placing already unviable loans in the ‘special mentions’ category (see chart) and additional measures are likely taken to artificially suppress the official NPL figures (i.e. perpetual roll-overs of existing loans). In a survey conducted in September 2015 by Oriental Asset Management, over 50% of risk managers in China believed that the official NPL ratio underestimates the real risk in the banking system. As the Chinese economy continues its slowdown in 2016, expect to see this indicator rise, however, keep in mind the real risk in the banking system is likely much higher than the figures the authorities would like you to believe.
In last quarter of 2015, the most popular economic expression in China was ‘supply-side reform’. In the West, supply-side reform is associated with the large tax cuts, deregulation, and the privatization movement initiated by Reagan in the US and Thatcher in the UK in the 1980’s. However, in China, the term explicitly rules out large scale privatization of state-owned enterprises. The current intention of supply-side reform is to make selected large SOEs even bigger and more competitive by reducing cost and producing goods that are of a higher quality. This would entail larger SOEs consolidating and absorbing capacity from smaller SOEs through mergers and acquisitions.
The embrace of supply-side solutions is healthy transition for the Chinese economy. In the past, Chinese authorities responded to economic slumps by persistently using demand-side tools to prop up the economy by engaging in deficit spending, infrastructure building, and credit generation. However, the authorities have realized this course of action is unsustainable and sustainable growth can only be achieved via growth in productivity. Supply-side reform is meant to address the issues of overcapacity in the Chinese industrial sector. Overcapacity plagues the Chinese economy because the presence of many ‘zombie firms’, firms that are economically unproductive but are kept alive by constant injection of fresh credit by the banking system. Since 2012, the debt-to-asset ratio of many sectors (i.e. mining and smelting industries) facing overcapacity has been steadily increasing as a result of sucking fresh credit from the banking system. This credit is used to create industrial products that are not needed and employ workers that firms cannot afford. Despite the good intentions of the Chinese authorities in reforming the moribund state-owned sector, the crux of the problem still remain: SOEs managers have to answer to multiple masters that often have conflicting policy objectives. For SOEs to be economically competitive, their managers must be able to make choices that are consistent with profit maximization. In a system that ultimately values social stability (i.e. no massive lay-offs), this is at odds with making SOEs more profitable and efficient. Until SOE managers no longer need to serve conflicting policy agendas, the problem of excess capacity and misallocation of labour and resource is unlikely to be resolved.
- Price deflation
As a direct consequence of overcapacity, industrial prices in China have been on a persistent decline for the past 46 months as supply exceeds demand. Perpetual decline in industrial prices is weighing down the capacity of the industrial sector to service its debt and poses a systemic risk to the entire financial system. The real interest cost is effectively rising as nominal revenue persistently declines and the cost of interest remains relatively constant. The majority of the weakness in industrial prices are found among the upstream industries of such as mining and raw materials and heavy industries such as steel making and shipbuilding. These industries are reflective of China’s past where growth was predominately investment driven and associated with capital accumulation. Prices in China’s industrial sector will finally see positive growth once the issue of overcapacity has been resolved and supply and demand is balanced. Until then, interest rate pressures will continue to weigh down on the sector forcing banks to roll-over their loans to an already over leveraged corporate sector that has little hope of repaying their borrowed funds.
- Capital outflow
For majority of the past 15 years China has been accumulating foreign exchange reserves as a function of their large current account surplus and fixed exchange rate policy. However, starting in 2014Q2, foreign exchange reserves began to shrink and the speed in which the PBoC is losing its reserves is keeping both policymakers and market participates up at night (the policymakers are probably kept up by fear while the market participates are kept up by jubilations). The reason behind China’s recent capital outflows is associated with the establishment of the offshore RMB market (known as the CNH) as the PBoC encourages the international use of the renminbi. However, by running a fixed exchange regime onshore (known as the CNY and whose price is set by the PBoC) and allowing the market to freely price the RMB offshore, this created a price differential that large corporate enterprises in China found a lucrative opportunity to arbitrage: the larger the price differential; the greater the profit from arbitrage; and the larger the capital outflow. By trying to stabilize the market’s expectation on the USDCNY exchange rate, the PBoC paid dearly in terms of foreign exchange reserves to defend its exchange rate. In 2015, the PBoC lost $513B in foreign exchange reserve as it defends its exchange rate from speculators and depreciation pressures.
A point that is often neglected when discussing the issue of capital outflows in China is that this is ultimately a desired policy outcome for the PBoC. In the long term, the PBoC wants to diversify their wealth away from holding low yielding bonds issued by a single entity: the US Treasury. The game of chicken the US Congress played (twice) with the debt ceiling also did not inspire much confidence in their largest single foreign creditor, the Chinese. The PBoC ultimately wants Chinese corporations to go abroad and purchase high yielding assets that can earn positive foreign investment income. As of September 2015, China’s net international investment position (NIIP) stands at $1.54 T (China owes much more foreign assets than foreigner own Chinese assets). However, for the past four quarters, on net terms, the Chinese still pay foreigners $97B in investment income. The reason behind this discrepancy in return is because the Chinese is predominately invested in US Treasuries that yield nearly zero return while foreigners are invested in high-yielding FDI that are economically productive in China. In itself, capital outflow is a means to accomplish the PBoC’s goal, however, it is the volatility of those flows that the PBoC cannot tolerant. Rapid outflows led to unpredictable movement in the exchange rate that the PBoC must defend by selling their foreign exchange assets. As the asset-side of the PBoC balance-sheet shrinks, so does the reserves on the liability side leading to shortfall in liquidity in the Chinese banking system. The multiple rounds of RRR cuts last year was not a signal for monetary easing but rather to ease a liquidity crunch that was building up in the Chinese banking system as a result of shrinking balance sheets stemming from capital outflows. Unless the PBoC can effectively decouple the value of the CNY from the USD, the next round of capital outflows will be inevitable as the Fed prepares for their next rate hike.
- Rising credit-to-GDP ratio
The word ‘credit’ stems from the Latin word ‘credo’ which means ‘to believe’. As the stock of debt in the Chinese economy grows relative to its capacity to repay, it is increasingly difficult to believe all of this debt can be fully honoured and repaid. Across a wide panel of historical data, a rising debt-to-GDP ratio is the best predictor of a financial crisis. Since 2008, the TSF-to-GDP ratio (TSF, or total social financing, is the metric the PBoC uses to measure broad credit in the economy) has jumped from 120% in 2008 to 204% in 2015 (204% underestimates the actual problem as TSF does not include on-book debt of governments, however, government debt should be the least of the worries). Much of this increase in the debt is associated with financing the 4T yuan stimulus package in 2008. Despite the slowdown in growth in 2015, credit generation continues to grow more than twice the speed of output. Much of this new credit generation is associated with keeping unproductive (zombie) firms running to fulfil social stability objectives of the Chinese government. However, printing money to feed current workers is not sustainable: this is akin to living on multiple credit cards and using the principal of a new card to cover the interest on the old. This house of card is glued together by one single factor: the credibility of the Chinese central government. Defaults are rare events in China and most asset prices enjoy a tight spread with the riskless rate because all risks are ultimately assumed to be backed by the central government. Should investors one day wake up and choose to no longer believe the Chinese state has the capacity or the willingness (or both) to support the current stock of debt, this house of cards will collapse leading to a major crisis. Given the obsession with social stability, this is a highly implausible result. However, continuation of business-as-usual will continue the problem of moral hazard in China and leading to more unproductive debt to pile up. Despite the ample policy room Chinese authorities enjoy, it is not infinite and it cannot escape the basic logic of a market economy: profit should be rewarded to those that are productive and those who made bad investments choices should experience loss. Should the Chinese government perpetually defy this basic economic logic, the Chinese real economy will enter into a Japanese-style decade (or more) of deflation and weak growth. However, unlike Japan, China does not have the luxury to enter this predicament at an advance stage of development with a well-functioning social security system. Ultimately, the Chinese authorities must make a delicate balance between moral hazard and systematic risk and enforce losses on some parties. Without this basic market mechanism, credit allocation will always remain suboptimal and the Chinese economy will perform under its amazing potential.