China’s increasingly high levels of debt have been a consistent focus of analysts in financial markets for a number of years.
Recently, some analysts have expressed concern that China is a stuck in a growing debt cycle, as leverage has to keep expanding in order for the country to reach its growth targets in the high-6% range.
And last week, a prominent Chinese banking analyst suggested that bad debts in China could be $6.8 trillion higher than the official government figures.
The rise of shadow banking in China has also come under the spotlight, as banks generate higher returns by offering riskier lending products that often aren’t recorded on company balance sheets.
Despite the rising debts levels, Woon Khien Chia, a senior portfolio manager at Nikko Asset Management, remains broadly positive on the outlook for China’s economy.
In a research note called “China’s deleveraging — when and how will it end?”, she also proposed a “game-changer” in China’s efforts to control financial risk: foreign capital from the global bond market.
Woon Khien noted that China’s corporate debt is now well in excess the average levels of both developed and emerging markets.
Despite concerns around high leverage in China’s shadow banking system, Woon-Khien said that deleveraging efforts have actually been underway for the last three years.
Policymakers initially targeted the broader economy, cracking down on debt-fuelled investments across commodities, manufacturing and real estate.
The focus shifted to financial-sector deleveraging at the end of last year. As part of that process the People’s Bank of China increased the inter-bank lending rate to reduce liquidity.
That led to the inversion of the yield curve for Chinese bonds in June — the rare scenario when the yield on shorter term debt exceeds the yield longer-dated bonds.
Yields on 10-year bonds are now back above 1-year bonds, and Woon-Khien the PBOC’s efforts to reduce leverage have had an effect.
“Credit growth has moderated and banks’ exposures to shadow banking and off-balance sheet wealth management products (WMP) have been reduced. Leverage in the bond market has also dropped,” Woon-Khien said.
Despite that, China’s overall debt levels remain worryingly high. Woon-Khien said that China’s credit gap is now 24.6% of GDP, which is well above the 10% threshold recommended by the Bank of International Settlements.
“Given the extent of over-leveraging, deleveraging should be a long haul for China,” Woon-Khien said. In view of that, she said that if policy makers opened up China’s bond market it would be “a big game-changer”.
“As the world’s third largest bond market, the Chinese bond market could potentially see an inflow of at least $US200 billion from the inclusions by the three main global bond providers – JP Morgan, Citibank and Bloomberg-Barclays,” she said.
Of course, opening up the bond market wouldn’t come without risks, as the PBOC would no longer be able to control both interest rates and exchange rates.
But Woon-Khien said that it’s clear China is already preparing for such an outcome, with authorities focused on managing short-term interest rates in recent years while gradually reducing their control over the currency.
Once capital flows are opened up, it means that policymakers won’t be able to reverse course if the economy continues to overheat. However, Woon Khien added that Chinese policy makers still have an extra option available in the form of quantitative easing.
“QE is still an available choice as the PBOC has conscientiously reduced its balance sheet in the aftermath of the global financial crisis unlike the G3 central banks,” she said.
However, Woon Khien thinks that the prospect of QE is still an unlikely scenario.
Whether or note China opens up its debt markets, there’s evidence to suggest that China’s economy is slowly integrating with global capital flows.
In June, the MSCI ruled that it will include Chinese stocks on the MSCI Emerging Market Index from next year.
In view of that, it will be interesting to see whether Chinese policymakers grant access to foreign capital in their efforts to get the country’s debt levels under control.
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