Mark Williams

Chinese debt – bearable burden or crisis-in-waiting?

Mark Williams

In the decade to the end of 2016, China’s total debt burden doubled to more than 260% of GDP, with much of the spurt in growth coming as a form of post-financial crisis stimulus. While trade wars and tariffs have caught investors’ attention over the past year, debt levels are still creeping up and recently breached 300% of GDP.

This is very unlikely to lead to the financial crisis predicted by some any time soon. Such debt levels mean significant reform is essential, but this process is already underway as part of the rebalancing and slowdown that is key to a positive outlook for investing in China.

Breaking down China's debt

It is undeniable that China’s debt burden has grown too far and too fast, but the 300%+ debt:GDP ratio give a misleading impression of how alarming the situation is. A lot of the country’s debt is effectively issued by government controlled entities (banks), at the bidding of the government, to government-controlled entities (State-owned-enterprises or local governments). This means that reorganising the debt burden should be easier than in a less centrally controlled environment. Or, in other words, what the western world would have issued as government funded debt, the Chinese government has lent via the banking system. These debts may not be a great business decision for the banks - they were never intended to be - but it does not mean they will all fail.

Importantly because both the lenders and borrowers tend to be government controlled, addressing issues as they arise should be possible. And we are seeing evidence that this is happening. China is broadening its bond markets, which would provide a much more suitable place for some of the longer-term loans (such as those to infrastructure projects) which have previously been funded by three year bank loans. Just as importantly, bond defaults are being allowed to take place. This is a relatively new phenomenon in China, but for the bond market to have any credibility, defaults and bankruptcies must be allowed to occur. For markets to function efficiently, there needs to be an acknowledgement of the risks which must accompany returns. Any indication that the government offers an implicit guarantee on borrowing leads to dangerous levels of moral hazard. Allowing companies to default on bonds is an important step forward.

China is also trying to reduce the scale of its shadow banking sector. This has been relatively successful, with far fewer new loans going through alternative lending sources and many loans being brought back onto banks’ balance sheets. This gives us confidence that the government is taking reform seriously and that it is capable of implementing necessary changes.

Such a complex and comprehensive rebalancing of China’s financial system at the same time as it tries to shift the economy to a more sustainable level of growth – less dependent on exports and more driven by services – is always going to be risky.

One main advantage that China has in managing this risk is its closed capital account and managed exchange rate. In the long-term, this restriction of capital movement is a black mark against China’s name when compared with the world’s major developed economies. But in the shorter term, while question marks remain over the size of the debt pile, capital controls allow authorities to exert some control over the situation. If holders of debt are restricted from panic selling and moving their renminbi overseas, then the vicious circle of capital flight and forced currency devaluation that would accompany a systemic debt crisis is largely negated

The control that China has over capital flows is reflected in the stability of foreign exchange reserves – currently it holds US$3.1tn of them. This is something we monitor closely and so long as any outflows remain low relative to this massive stockpile we retain our confidence that the debt situation should be manageable.

China's tight grip on foreign exchange reserves

If we are right, China’s debt burden is not going to derail its economic growth but it will hold back certain areas. Our job is to identify areas where ongoing domestic demand or government-supported investment can lead to longer-term growth. We will avoid moribund companies in industries with overcapacity that have been kept alive for employment rather than profit – it is these areas that will be vulnerable as market mechanisms are allowed to operate, with companies allowed to drown under unsustainable debts rather than bailed out.

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Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Asia team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The Fund’s expenses are charged to capital. This has the effect of increasing dividends while constraining capital appreciation. 

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Thursday, October 31, 2019, 11:23 AM