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All cower and tremble before the terrible and slowing economy of China!
It sounds so totally and completely ridiculous when said like that, although in truth, that is probably the most accurate way in which investors’ reactions to the onslaught of confusing and contradicting information coming out of China can be described.
Markets are confused and a little more cautious than usual, and there is certainly no shortage of opposing views on what the future holds for China, and the rest of the world economy, to help spur on the current risk-off attitude in markets.
So in an attempt to understand what is actually happening, let’s explore some of the facts that we have at our disposal and what their potential impact could be on our, and world markets.
The fact is that the Chinese economy is slowing down. Now, there are some discrepancies between official government GDP data and that of independent economists and analysts, although the overall trend is similar.
The official data released by the Chinese government states that the 2015 GDP growth rate was 6.9%, below the magical 7% mark that the market has come to accept as the absolute minimum rate of growth for the Chinese economy in order for global markets to not to be too adversely affected.
What is perhaps more concerning is that independent global advisory firm Oxford Economics estimates that the actual 2015 Chinese GDP growth rate was 6.3%. It cites differences in how the GDP input data is measured and states that the data being used by the Chinese government is “too smooth” to be trusted.
Digging into the various figures
This does not mean that the Chinese government is lying to the whole world about what is happening in its economy, it simply means that there are institutions out there that believe that there are more accurate ways in which to calculate the statistics on which the world markets have come to rely on so heavily.
Other notable independent institutions that analyse economic data are of course the ratings agencies. Recently Moody’s downgraded its outlook on China from Moderate+ to Moderate with a negative outlook.
Admittedly these ratings scales and methodologies can be rather confusing, but in essence they measure the risk associated with owning debt by either a company or a country.
Moody’s downgraded China’s sovereign debt rating citing the weaker yuan, very high levels of property-based debt, lower levels of imported goods, lower prices of commodities in general and less room for monetary policy to successfully steer China clear of the momentous economic headwinds that the country is facing.
It is currently forecasting Chinese GDP to come in at 6.3% for 2016 and to shrink further to 6.1% in 2017, with the slowdown mostly concentrated within the heavy industry, or manufacturing, and importing sectors.
This is bad news and – if accurate – will no doubt lead to even lower commodities prices and further pressure on economies such as ours in South Africa.
Zombie firms and debt levels
It is also worth mentioning that Moody’s subsequently downgraded 25 non-insurance financial institutions in order to bring their ratings in line with China’s sovereign rating.
On the surface this looks rather run-of-the-mill, although a number of these banks have been on negative watch for a while, so it would not be all that surprising if we see more downgrades in the near future in this particular sector.
Even though monetary policy is accommodative, credit conditions are tight and with the sheer number of manufacturing firms only managing to survive on lines of cheap credit from the banks – also known as zombie firms – to provide them with cash flow as they essentially run at losses, it raises concerns around the stability of the banking sector during times when their customers are not earning any money and getting themselves into an ever-deepening pit of debt.
Currently China’s debt levels are around 250% of GDP and with GDP slowing and levels of credit growing, this does not bode too well for long-term sustainability.
A monster has already been created and is now being fed more and more as Chinese authorities desperately try to stimulate economic expansion. It appears to be a vicious cycle that has only one outcome…disaster.
Ghost cities and a shadow banking system
Let’s look at this debt problem a little more closely in order to try and understand exactly what is causing it, and what the potential outcome could be.
Research has shown that asset bubbles that are fuelled mainly by equities are usually not that destructive when they inevitably burst, although if bubbles are fuelled mainly by debt, the damage is far greater and longer lasting, often leading to major recessions.
China has experienced a decade-long boom in property prices, more than likely fuelled in its later stages by speculators trying to ride the momentum of ever-increasing property valuations.
Many of these properties were financed by a variety of rather creative debt instruments sold to individuals by Chinese banks. What they would do is essentially create a trust company that borrows money from individual Chinese investors by selling them what are basically just high-yield junk bonds.
The monies raised by these activities would then be invested into real estate or in companies related to real-estate development – a fantastic way to get an economy to grow above 10% for a decade on the back of construction.
The problem is though that many developments are standing empty – ghost cities are commonplace in China – and property prices have been steadily declining from late 2014 to date.
This shadow banking system that helped fuel the debt-based property boom could well be the very thing that brings down the banking system in a USA 2008-style subprime mortgage crisis as property valuations tumble.
Combine this with the aforementioned zombie firms and we have the makings of a potentially bigger crisis just waiting to unfold.
Now, you would think that in order to stop this problem in its tracks, or at least try to resolve it in some way, that you would have to reduce the amount of loans you grant.
Instead China is easing monetary policy by lowering benchmark interest rates and also, interestingly, lowering the required bad debt coverage ratio that banks are required to have.
Historically this bad debt coverage ratio was 200%, although recently this has been reduced to 150%, which of course leads to banks lending more money.
Sure, perhaps the percentage of bad loans in comparison to total economic activity is rather small at 1.7-odd percent of GDP, but this is easily kept down by simply granting more loans. When we look at the absolute value of outstanding bad loans it paints a completely different picture.
*Petri Redelinghuys is a trader, equity and equity derivative portfolio manager in Johannesburg.
This is an excerpt from an article that originally appeared in the 7 April 2016 edition of finweek. Buy and download the magazine here.
