China's debt challenge is different

Rene Buehlmann explains why China's debt challenge is different and what trends will define 2018.

09 Jan 2018

Lessons from the Global Financial Crises

If China's debt challenge is a significant concern for local and global markets, how can investors be confident that China is putting the right policy measures in place to address its growing debt pile?

By comparing China's situation with those leading up to past crises, it's clear that China's challenge is different and that the government has learnt the lessons from the past and is applying policies that make a domestic crisis highly unlikely, according to Rene Buehlmann, Head of UBS Asset Management for Asia Pacific.

What happened in the past?

The Asia Crisis happened when Asian countries' huge dollar-denominated debts became unsustainable in the late 1990s. Investors rapidly withdrew money across the region, causing a balance of payments crisis, forcing sharp currency devaluations and a widespread crisis.

In contrast, the Global Financial Crisis in 2008 stemmed from excessive leverage, misallocation of credit to subprime households, unregulated lending to the economy through 'shadow' banking channels and poor underwriting standards.

What parallels does China have with past crises?

Looking at the Asia Crisis, there are some similarities, mainly through the build-up of debt and possible inefficient allocation of credit to concentrated areas of the economy.

Looking at the GFC, China's recent experience of rapid credit growth, the emergence of wealth management products and shadow banking, plus large swings in housing and equity markets, have some similarities to conditions prior to the start of the GFC.

How is China different?

While it's true that China has a large and growing debt burden - equal to 257.64% of GDP at the end of 2016, compared with 161.1% in 2006 - the debt situation is quite different to those that caused the aforementioned crises.

For starters, while it's true that there has been some inefficient allocation of credit, debt is concentrated differently in China. Debts are largely owned by state-owned enterprises and owed to the government, which means the government can coordinate orderly debt restructuring.

Also, almost all domestic debt is financed via Chinese banks, and external, dollar-denominated debt is low, which means little or no risk from the massive withdrawals by outside investors which caused the Asia Crisis.

Furthermore, China has a very strong trade position. China's large balance of payments surplus, plus enormous FX reserves and capital controls, protect the financial system from capital flight.

China has a high savings rate, which means banks have huge capital resources. Domestic savings are very high and capital markets are under-developed, so saving largely exists as deposits or quasi-deposits in the banking system to finance debt.

Finally, and most importantly, China's regulators have learnt the lessons of the past, are well aware of credit growth and the shadow banking system, and are taking steps to rein in excess debt growth. These factors, combined with the above points, mean that a domestic financial crisis in China is highly unlikely.

How has China learned the lessons of the past?

China is proactively controlling debt growth through its deleveraging policy that has tightened regulations, gradually increased interest rates, and dramatically slowed the growth of credit. So much so, that growth in the money supply has recently reached historic lows.

Shadow banking has been brought under control through a series of new regulations, such as controls on wealth management products and increased oversight by regulators that have stemmed the flow of off-balance sheet capital into the economy.

The housing market has been brought under control through a series of tightening measures that have been rolled out through the economy. New policies to restrict speculative investment and promote rental housing are good for the long-term growth of the sector.

SOEs are being reformed and zombie companies are being closed down, thus closing off a highly inefficient part of the economy.

What more needs to be done?

But China can go further, and investors can look for government efforts and mitigation measures in the following areas to promote the health of the financial system:

  • Improved banking governance to ensure that the most worthy firms get access to financing and that growth in non-performing loans gets brought under control.
  • Improved efficiency of state-owned enterprises to boost long-term corporate profitability, improves balance sheets, and limit overcapacity.
  • Transparency of informal lending and the continued reining in credit expansion to ensure orderly management of debt while still financing economic growth.
  • Reviewed money market fund valuation practices to ensure transparency, liquidity, and orderly market functioning by transitioning to a mark-to-market valuation approach.
  • Continued opening of financial markets to encourage inward investment to offset capital outflow pressures and to open the country to new technologies. Also, opening financial markets can help international diversification of domestic investor portfolios and remove pressure from domestic equity and housing markets.

In conclusion……

In sum, considering the differences between China's debt situation and those that caused past financial crises, plus the substantial measures that China is taking to address its debt challenge, we believe a domestic debt crisis is highly unlikely.

While the control measures that China is applying may result in slower growth in the future, these measures - plus the wide-ranging reforms being made - will support more sustainable development and enhance China's long-term growth prospects.

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