For global investors and, indeed commentators, China remains a fascinating subject and one that carries a health warning.
For global investors and, indeed commentators, China remains a fascinating subject and one that carries a health warning.
Nearly a third of fund managers say the recent tightening of credit by authorities in Beijing, who are taking aim at the shadow banking sector, is now the biggest tail risk for markets, according to a Bank of America Merrill Lynch survey released this week. Not since January of 2016 has China ranked above the threat of a eurozone break-up as the biggest worry for investors.
The catalyst has been Beijing’s belated effort to bring an enormous credit bubble under control. As a result, interbank lending rates have shot up, while five-year bond yields have risen above those of the 10-year sector - both signs of financial tension that reflect the crackdown on leverage.
The broader concern is that a decelerating China, squeezed by tighter financial conditions, represents a double hit to the global reflation trade. It comes just as doubts grow about the ability of the Trump administration to implement pro-growth policies as political controversy sucks up the oxygen in Washington.
What the taming of China’s mighty credit bubble means for the global financial system was very much on the minds of readers who attended an FT event in London this week, which featured George Magnus, an associate at the China Centre at Oxford university. Mr Magnus, who is writing a book about what he describes as the five traps facing China - debt, capital, demographics, middle income and Thucydides, faced an audience looking for insight on these and other topics.
Kicking the event off, I asked the audience whether they thought China was a bubble. More than half of the 70 people in attendance raised a hand.
Characterised by a series of ferocious asset price surges in recent years spanning equities, property, commodities, and even bitcoin, it’s hard not to dismiss anxiety about bubbles whenever the conversation turns to China.
The explosion of credit has been powering China’s economy in recent years. When measured against GDP, the ratio of credit has jumped from 141 per cent at the start of 2009, to 260 per cent by the end of 2016.
Not surprisingly both the IMF and BIS have expressed alarm at China’s credit gap, or the deviation of credit growth from its long-term trend. The IMF warned last year, China’s credit gap is very high when compared ‘’to countries that experienced painful deleveraging, such as Spain, Thailand, or Japan’’.
For all the mind-boggling numbers on debt, the excessive use of leverage and an explosion in the use of off-balance sheet wealth management products, few investors expect a macro shock ahead of China’s 19th party congress this autumn. One major difference between now and the recent bouts of turmoil is a stable renminbi and a cessation of capital outflows. That has eased the risk of a global deflationary shock, a prospect that animated international markets at the start of 2016 and, just as violently, in August of 2015, when the renminbi was suddenly devalued.
Yet as China keeps the pressure on its shadow banking sector, domestic investors may begin to be tempted by foreign assets and, as analysts at UBS recently noted: ‘’thereby putting pressure on the currency and changing the game’’.
Perhaps. But as Mr Magnus told the FT audience, any dramatic slowing of the economy this summer before the congress will prompt Beijing to back off from squeezing liquidity conditions too hard.
A sense that China can muddle through and keep the debt show on the road was also reflected by some in the audience. Given that much of the debt sits with state-owned entities or those backed by the government, there’s no reason to think a western style banking insolvency crisis that takes the economy with it will arise any time soon.
Not so fast, responds Mr Magnus, warning that the shadowy financing of the debt through interbank and repo lending is an Achilles heel for China. The funding structure of such liabilities does have a timeline that is much more immediate than the state rolling over SOE and bank debts. A shadow-funding crunch with lenders steadily shut out of the system, and going bust with potentially dire consequences for the rest of the financial system could well play out between six months and two years from now, he estimates.
That’s why the decisions taken at the congress later this year will be pivotal for understanding the long-term fallout from years of easy money and rampant credit creation.
Whether Beijing is genuinely serious about tackling the credit bubble at the cost of economic growth sliding well below the current target of 6.5 per cent represents an ‘’acid test’’ says Mr Magnus. ‘You can’t resolve a debt problem peacefully,’ he adds.
