From nicotine to alcohol: China’s continued addiction to credit-intensive growth

Last Friday, China’s GDP data for the first quarter of 2016 was released and it gave financial markets a sign of relief that the world’s second largest economy continues to hum along at a steady pace (at 6.7% y/y) with the tertiary sector continuing to drive growth.


GDP growth by sector

Among the good news was that price levels are starting to recover. For all of 2015, the GDP deflator – the difference between the nominal and real GDP growth rate – was negative, implying that nominal indicators were dragged down because of falling prices, as opposed to falling levels of production. The falling price level infers that revenue- given the same unit of sales- is shrinking and would weaken firms’ ability to meet their interest payments, which are mostly conducted on a fixed basis. As price level recovers, then firms would have an easier time meeting their financial obligations and this reduces the pressure on financial markets as the risk of defaults is reduced. However, the bad news is that despite continued strength in headline GDP, the composition of growth does not appear to be the high quality growth the authorities have been preaching nor is it the type of growth that is sustainable and assists in the process of economic rebalancing in China.

Throughout 2015, much of China’s growth was driven by expansion in financial intermediation, the result of a state-led equity bubble in first half and the exploding bond market due to monetary easing in the second half. The heighted level of activity in capital market increased trading volumes and expanded the balance sheet of the financial services sector. This in turn drove economic activity that propped up GDP growth. As the bond market calms down and the equity markets remain moribund, activity in the financial services sector has returned to the more sane levels seen prior to the equity market bubble. However, as one source of unstable growth dies down another is revived.
Tertiary sector growth by component

construction value added

Real estate has traditionally been the driver of China’s economic growth. Yu Yongding, from the Chinese Academy of Social Sciences, estimates that real-estate accounts for more than 10% of GDP. With growth in the other sectors dragging, executing a list of shovel-ready projects has always been regarded as a reliable source of growth to meet economic growth targets. Indeed, it seems like the Chinese government has not learnt its lesson from the equity-market bubble last year when official media outlets encouraged households to enter into the stock market. In a similar fashion, the Chinese government is pumping up demand to spur a recovery in the real-estate sector to compensate for the lack of real growth in other areas of the economy. In November 2015, the central government relaxed mortgage down payment ratio for first-time home buyers to 25%, down from 30%. With the discretion of local governments, the ratio can be further pushed down to 20%. Combined with five cuts to the required reserve ratio in past 18 months, this created an environment where the quantity and price of loans became more accessible. With the stock market weakening by the second half of 2015, it is natural that Chinese household redirect funds into their most reliable asset class: real-estate. Indeed, since November change to the down payment ratio, nationwide real-estate prices have increased 12% with extreme markets, such as Shenzhen and Shijiazhuang, up 40% in 2015.

national property price index

However, a real-estate led growth isn’t what most had in mind when one thinks of ‘sustainable’ economic growth in China. Real-estate investments are extremely capital intensive and exposes its financier to a very high level of maturity transformation. By promoting real-estate as its latest source of growth, the Chinese government is exposing the financial system to greater financial fragility as short-term funds must be raised to finance this very long term asset. With 700 million square meters of unsold residential floor space in 2015, it begs to wonder why more real-estate needs to be built to satisfy demand that may be high speculative in nature.

By relying on real-estate to support economic growth, the Chinese government has yet to convert or begin to turn to a more sustainable growth model that is not dependent on excess credit generation. Regardless of which index of credit one monitors, one conclusion is clear: the Chinese economy continues to be more indebted and financial fragility continues to build. Many articles have been written on the sustainability of this debt and the many tools the Chinese government has at its disposable to deal with future debt problems – I agree with all these points. However, the more the government delays in addressing issues of overcapacity and unbalanced growth, the more painful it will to be resolve such issues in the background of an aging society and pressing social security needs.

In conclusion, it appears that the Chinese government continues to value short-term economic growth at the cost of financial stability. The authorities continue to use time-proven solutions of fixed asset investment (especially in the real-estate sector) to address short-term macroeconomic deficiency. Despite having been badly burnt in last year’s equity market bubble, the government seems ready to bet again (this time in the real-estate sector) to keep the economy humming. In the short-term, the risks are likely to be limited. However, by ensuring stability in the near term, the government may be risking greater instability in the future.

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And the award for the province that is rebalancing the fastest goes to…Shanxi!

Official Chinese state media often points to the growing service sector has a sign of China rebalancing away from an unsustainable investment-driven model of growth to a service-based economy that is more modern, environmentally-friend and represents the future of Chinese growth. Recently on the front covers of China Daily[1], the state paper proudly presents that 50.5% of the Chinese economy is now service-based and the process of rebalancing is moving along smoothly. However, if we inspect under the hood of the rebalancing process, several important questions emerge regarding the relevancy and sustainability of this figure.

1) Much of Chinese growth is driven by an expanding financial sector

Analysis of China’s nominal GDP growth is quite telling. The most often quoted GDP statistic in China is the real GDP that removes the effect of price changes to calculate the actual changing production capacity of the economy. However, when analyzing the financial sustainability of the rebalancing process; especially the sustainability of the firms in the real economy to meet their financing cost, nominal measures matter and represents a more accurate description of the cost pressures of enterprises. If we analyze the rebalancing process in China using nominal GDP, it is clear that since 2012 the growth in the tertiary sector has by far outstripped that of the secondary sector.

Nominal GDP by sector.JPG

The tertiary sector, as defined by the National Bureau of Statistics (NBS), is the summation of several broad categories, mainly: transport; storage & post; wholesale and retail trade; accommodations and catering trade; financial intermediation and real estate. Surprisingly, the NBS used to publish many other categories when calculating the tertiary sector (i.e. leasing of commercial services, education etc.), however, they stopped releasing the data for these categories after 2012. The five categories I listed currently represents 60.7% of the tertiary sector. The missing 39.3%, I will denote as ‘Other’. Conversations with contacts in Beijing indicates much of this ‘Other’ category is associated with government spending. With that in mind, let’s look at the evolution of the components of the tertiary sector overtime.

Nominal growth in tertiary sector.JPG

From the graph above, it is quite clear that much of the strong growth in the tertiary sector, and hence a fair chunk of GDP growth, actually comes from strong growth in the financial sector. Without the strong contribution from financial intermediation, in 2015, the tertiary sector would have grown at 9.6% and nominal GDP at 5.1% (as compared to respectively 11.7% and 6.4%).

In itself, there is nothing wrong with growth in the financial sector. However, having a booming financial sector in the backdrop of a slowing economy is a receipt for disaster. Financial activity can be productive that enhances the efficient allocation of resources in the economy. However, as the Global Financial Crisis can attest to, financial activity can also be speculative that misallocates resource and distorts the pricing signals of the economy. With widespread evidence of financial excesses, as seen in the equity bubble in the first half of 2015 and the exponential rise and subsequent failures of P2P funds (i.e. E Zhubao) recently, it is safe to say that at least some of this financial activity is unproductive and is likely to harm the economy. Estimates from by Logan Wright from Rhodium Group demonstrates that, finance as a sector, is a now larger in China than in the US (see chart). Historical experience consistently demonstrates that, a rapidly expanding financial sector is often linked with financial crises.

financial sector as a share of GDp.JPG

2) Many unlikely provinces are experiencing a boom in the tertiary sector

What is more shocking to me is not that the service sector is driving Chinese growth. The government often touts e-commerce and the rise of firms like Alibaba with their dominant online payment system, Alipay, as the solution for China’s sagging growth. What is shocking to me are the provinces that are experiencing the fastest growth in the tertiary sector.

The chart below details the year-over-year growth of the tertiary sector versus the secondary sector of 25 Chinese provinces in 2015. NBS keeps track of 31 provinces but only 25 to date has uploaded their provincial GDP data by sector for public use. The 6 provinces that have not yet provided their 2015 data are: Liaoning, Heilongjiang, Yunnan, Tibet, Gansu and Xinjiang. It would definitely be interesting to see the rebalancing process in the North-Eastern provinces, but these six provinces are not the drivers of Chinese growth and the remaining 25 should provide us with a decent picture of the overall situation.

secondary versus tertiary sector growth.JPG

If we measure the rebalancing process as a booming service sector compared to a slowing industrial sector (essentially the difference in growth rates between the two), then clearly Shanxi is the winner. If we recalculate the data from the chart above, purely in terms of differences between the growth rates of the tertiary sector versus the secondary sector, then list would look like the following chart.

rebalancing index.JPG

What I found astounding in this chart is that Shanxi won by a huge margin. Shanxi led the nation not only in terms of contraction of its industrial sector, but also in terms of increase to its service sector. My immediate reaction to this result was one of skepticism. From my general recollection of news in China, there has not been any amazing innovation coming out from Shanxi to justify a nominal tertiary sector growth rate of 19.6%. In addition, because of the dominance of heavy industry in Shanxi and the collapse of that sector in 2015, Shanxi’s nominal GDP growth was actually 0.3%. One possible explanation for this intense growth in the tertiary sector is heavy government spending to prop up the local economy. Preliminary data released by Ministry of Finance shows that in 2015, the combined (both local and central government) on-balance sheet fiscal deficit was 3.5% of GDP, up significantly from 2.1% in 2014. The increase in the fiscal deficit does not included the off-balance sheet spending conducted by other arms of the government (i.e. the policy banks, LGFVs and SOEs etc) which also saw significant increase in activities in 2015. If the huge growth in the service sector is caused by a strong surge in government spending, it calls into question the sustainability of this growth and the entire rebalancing process itself. One of the intentions of the rebalancing process is to move away from a debt dependent model of growth. If my observations are correct, essentially the government is substituting corporate debt used for investments to public debt used for consumption: this is a trend that is neither sustainable nor desirable. Despite having better environmental effects, the continued dependency on debt does not change the core of Chinese growth model and continues to accumulate financial sector vulnerabilities.

Moreover, to connect my second point to my first point, we know nationally, much of the increase in the service sector is supported by strong growth in the financial sector. The 2015 data for the provincial breakdown of the tertiary sector by components has yet to be released, however, logically we can expect many provinces to experience strong growth in financial intermediation[2]. Can we imagine the provinces that are rebalancing the quickest to be productive users of increased financial services? If we look at the top five provinces that are rebalancing the fastest: Shanxi, Qinghai, Shanghai, Hebei and Shaanxi, outside Shanghai all the other provinces are dominated by heavy industries associated with China’s current slowdown. Is their strong growth in the service sector productive or is it financing for zombie companies that will inevitably need to be restructured?


Official media often regards economic rebalancing as switching growth from the secondary sector to the tertiary sector. Much of China’s current growth in the tertiary sector is driven by increased activities on the part of the financial sector. Finance ultimately is a tool that attempts to better allocate current resources and does not create new wealth in the economy. Ample amount of evidence points to the financial sector supporting unproductive activities in the Chinese economy and brings into question towards the sustainability of this growth. When we define rebalancing as the difference between tertiary and secondary sector growth, we find some unlikely candidates to be rebalancing the quickest. These unlikely results question the underlying GDP data itself, and combined with the national trend of increased financialization, paints a picture of a dangerous situation where much of the financing occurs in economically weak areas of the country.


[2] Since the national average growth rate in financial intermediation was 23.2%, many provinces would actually have seen finance grown faster than this.

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A financial crisis with Chinese Characteristics

Recently there has been a lot of media attention on the increased probability of an imminent financial crisis in China because of the continual built-up in financial sector vulnerabilities. With the recent memory of a financial crisis in the US, many commentators are drawing parallels and arrive at the inevitable conclusion that China too must experience something similar. Before diving into the specific mechanics of how a financial crisis can actually unfold in China, it is important to appreciate the differences in the two systems. These differences will ultimately determine how the mechanics will play out, the response of policymakers and the ultimate conclusion. The main differences I can easily recall are:

China (2016) US (2007 – Pre-crisis)
Main source of financing to the real economy Bank loans Lightly regulated money markets
Financing of major financial institutions Deposits (stable) Money markets (unstable)
Legislative authority to act Largely unconstrained, the Chinese authorities can lend to whoever they want, whenever they want with no limits on quantity (i.e. equity market rescue in Aug 2015) Legally and ideologically constrained. The Fed had no authority to lend to investment banks or money market vehicles that was at the heart of the crisis.
Source of financial vulnerability Corporate sector debt mostly linked to unproductive SOEs Household sector linked to subprime mortgages
Financial capacity of government Nominally strong, but uncertain once all the liabilities of local governments and SOEs are included. Relatively strong, federal debt at 40% of GDP.
Monetary policy Constrained due to the trade-offs of maintaining a fixed exchange rate. Independent
Predominant government ideology Social stability Market discipline and prevention of moral hazard

What are the sources of vulnerabilities in China that can start a financial crisis?

It is almost impossible ex ante to identify the exact sparks that would start a financial crisis. (i.e. In 2006, the US Treasury conducted an exercise to identify a potential source of a future financial crisis, no one predicted the crisis would have come from subprime mortgages[1]). However, we do know several points of vulnerabilities that can exacerbate into a crisis. Whether these vulnerabilities will materialize into shocks to the financial system will depend on the reaction of market participants and policymakers.

  • High levels of debt in the corporate sector, mostly issued by unproductive SOES that operate in sectors that are grinding to a halt if not in outright contraction.
  • Large amount of outstanding local government debt issued by LGFVs with many provinces clearly insolvent and unable to pay off their stock of debt by any realistic forecast of cash flows.
  • A rapidly developing and evolving shadowing banking system that is competing away deposits from the traditional banking system to earn high rates of return through opaque channels[2].
  • A growing number of small banks who are competing for deposits and market share and are willing to enter into business the dominant banks have shied away from[3].
  • Large capital outflows that can lead to a drying up of liquidity in the interbank market if not properly managed.

What would the mechanism of a Chinese financial crisis be?

Despite the uncertainty regarding the asset side of the Chinese financial system, one point is clear, the wealth management products (WMP), is likely the weakest link on the liability-side. Unlike deposits of the banks that are now guaranteed up to 500,000 RMB by a deposit insurance fund, the WMPs are very short-term investments (usually 3 months) that are advertised to be liquid and riskless. The WMPs now represent a major part of lending to local governments and firms operating in the real economy. As of June 2014, the Reserve Bank of Australia (RBA) estimates that the stock of financing provided WMPs stood at 17.2T, or 15% of the stock of total social financial during that time[4]. Despite the relatively small share this investment vehicle plays compared to overall financing, due to the liability structure of these funds, this source of funding can disappear in a relatively short time should there ever be doubts among investors regarding the quality of the underlying assets and the extent of implicit guarantee provided by the Chinese authorities. The ultimate problem is that WMP engages in maturity transforming but without the proper safety precautions to safeguard against insolvency or panic runs sparked by worried investors.

In addition, these shadow banking conduits poses a real risk towards the actual banking system because of the implicit relations between the two. Despite being a legally separate entity, investors often assume all WMPs sold by commercial banks are guaranteed by the selling bank. So far the market results have proven the investors’ instinct to be correct. Every episode of a near default has the government scrambling to provide a solution to protect investors from loss despite the contract clearly stipulates many of these WMPs are not in any way guaranteed. The typical chain of WMP can be view in the following stylized way.

Anatomy of WMP

Source: (Hachem and Song, 2016)

Similar to the SPVs set up in the US before the Global Financial Crisis, the idea was that these vehicles can take risk independent of the sponsor and any economic consequence will be restricted to the SPV. However, as the case with Bear Sterns clearly shown, the reputational risk of being labelled as unable to honor the commitments of their SPV, will link the risk back to the issuing firm regardless of the legal structure. Once Bear Sterns began dedicating its own capital and liquidity to protect their SPVs, this brought unforeseen risk on to its balance sheet and a run by its creditors. When greed turns to fear, what seemed to be a very liquid environment can turn into a desert almost overnight. With the market suspecting the asset quality of Bear Sterns, the fear became a self-fulfilling prophesy; creditors demanded greater collateral and withdrew deposits. Within the matter of a week, Bear Stern went from being the fifth largest investment bank in the US to being acquired at $2 a share in a government sponsored bail-out simply because liquidity evaporated.

This chain of event is unlikely to occur a large bank in China because of their access to near unlimited liquidity from a generous central bank and widespread recognition in the Chinese market of a large bank’s systematic importance.  However, a Bear Sterns-like type of crisis, where an off-balance vehicle had to be placed on balance sheet, is not an impossible situation to imagine for a smaller bank. Smaller banks were responsible for the most aggressive promotion of WMPs because of the binding limits on the amount loans they could have made from a small deposit base[5]. Hachem and Song (2016) estimated that between 2008 and 2014, small banks were responsible for 73% of all new WMP issuances. It is not unforeseeable to see that as the real economy continues to slow, some of the assets of the more aggressive WMP begins to fail as a result of some exogenous shock. Given that much of the funds in WMPs are invested in troubled sectors such as real-estate and construction, a default by a major firm in this sector can be enough to trigger a loss of confidence and commence a run. The biggest single factor in this scenario is the response to policymakers: will they communicate that the government will essentially honor the liabilities of the entire financial system (or at least the parts that are in most stress)? If not, the moment doubt is instilled into the minds of investors, a cascading effect of contagion was quickly spread to other asset classes[6].  However, if the government does communicate it will protect the liabilities of the entire financial system, then the market will to begin to question the solvency of the state and whether such a commitment is credible (i.e. the case with the response of the Irish and Spanish government).

investment of AUM

In order to stem a panic, the issuing bank (in this case a smaller bank) will honour the liabilities of this WMP. Given the opaque nature of the WMP, deposits and creditors of this bank may begin to pull their deposits from the sponsoring bank starting a classic bank run[7]. In a system that values stability above all else, it is most likely a small bank would be bail-out either in an acquisition by a larger bank, or by perpetual assistance from the state. But despite the protection guaranteed by a larger institution, trust in WMPs as a viable savings instrument will be affected, leaving this source of financing to be unreliable going forward.

What would a financial in crisis in China look like?

In a system whose basic logic is to preserve stability, it is very improbable that China will face a Lehman-like moment where a major financial institution is allowed to fail. Instead, given the similarities in development-model, China would face a crisis similar to what Japan experienced in the 1990s: a long drawn out process in which growth grinds to a halt and the economy is plagued by ‘zombie’ firms that is dependent on constant injection of fresh credit to remain alive and distort factors in the real economy for productive firms.

A paper published in 2008[8] details the consequences of lending to zombie firms had serious consequences in terms of productivity gains in the Japanese real economy. Perpetual rollovers of noneconomic loans allowed Japanese banks and authority to play the game of ‘extend-and pretend’.  This game prevented Japanese banks from recognizing bad loans in orders to meet regulatory requirements and avoid the sharp reduction in profits that would have accompanied recognizing NPLs. By keeping zombie borrowers alive, these unproductive firms distorted factor markets by artificially keeping wages high and the prices of outputs low as unprofitable firms continue to produce. These two distortions were a two-pronged attack on productive sectors of the economy: revenue was artificially suppressed while labour cost were higher than otherwise. These unfavourable factors discouraged productive investments from taking place, prolonging Japan’s economic slump.

These dynamics can easily play out in China with the political connections of many SOEs and the concentration of SOE activity in the less-dynamic regions of the country. The biggest threat to the Chinese financial system is not a cataclysmic collapse, but the failure to finance the full potential of a booming economy because of the inability to let go past legacy assets that are not representative of China’s future.


By solely observing the asset side, it is impossible ex-ante to identify the exact source of vulnerability that will lead to a crisis. However, if we monitor the liability side, we can observe severe deficiencies in WMPs that can be potentially be a source of stress for the system in the future. Given the basic differences in the two systems, a financial crisis will look very different in China than it did in the US. However, this difference does not subtract from the potential severity of the event or its consequences. By observing the experience of Japan, this episode serves as a baseline model for the consequences of a financial crisis and the implications it may have for the real economy.





[2] Hachem and Song (2016) described the parallels between WMPs and asset-backed commercial paper (ABCP), a tool of contagion for the GFC: “In this regard, there is a notable similarity between unguaranteed WMPs and the asset-backed commercial paper vehicles that collapsed during the 2007-09 financial crisis. Another similarity is the use of implicit guarantees and/or back-up credit lines by the sponsoring bank to allay investor concerns about the riskiness of off-balance-sheet products. As a result, the products are only off-balance-sheet for accounting purposes.”

[3] To reflect the growing importance of small banks to the system, in 1995 the Big Four Chinese commercial banks held 80% of all deposits. By 2005, this fell to 60%, and in the present, it is estimated to be around only 50%.

[4] For a more complete discussion behind WMPs please see

[5] Hachem, Kinda and Song, Zheng Michael, Liquidity Regulation and Unintended Financial Transformation in China (January 2016). NBER Working Paper No. w21880. Available at SSRN:

[6] One of the lessons of the GFC was that despite the relatively small size subprime mortgages were compared to the entire system, the entire system was paralyzed with fear and doubt. During a financial crisis, it mattered less whether a firm had good assets, but more so on how they were financed. Firms that had nothing to do with subprime found themselves in a credit crunch and in need of a government bail-out (i.e. Northern Rock) because they were very dependent on having access to very short-term and liquid debt.

[7] Having a deposit insurance fund does not guarantee bank runs will not happen. Firstly, deposits are only guaranteed up to 500,000 RMB, any surplus will be at risk of loss giving depositors with excess deposits very high incentive to withdraw their funds at any suspicion of a bank’s assets. Secondly, during the height of the GFC, Washington Mutual experienced severe run on its deposits despite being an FDIC-insured bank. Given the novelty of deposit insurance in China, it is not imaginable to see Chinese depositors lining up once news of a crisis breaks.

[8] Ricardo J. Caballero & Takeo Hoshi & Anil K. Kashyap, 2008. “Zombie Lending and Depressed Restructuring in Japan,” American Economic Review, American Economic Association, vol. 98(5), pages 1943-77, December

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Five Symptoms of a Sick Monkey

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.

  1. 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.

Rising special mentions

  1. Overcapacity

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.

  1. 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.

Falling PPI

  1. 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.

China Sept NIIP

  1. 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.

Increasing TSF-GDP

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