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MACQUARIE: China's debt is fine

Nothing to see here. Picture: 20th Century Fox

If there’s one thing that markets like to get roiled up over, it’s the state of the Chinese economy, particularly when it comes to its mounting debt levels.

Whether it be a noticeable deterioration in Chinese economic data or a scenario that we’re currently witnessing where there’s been a rapid expansion in credit growth that’s fueled a surge in construction activity and house prices, harking back to the “Old China” growth model, nothing seems to appease those investors who believe that it’s only a matter of time until the nation faces a so-called “Minsky moment”.

For those who aren’t aware, a Minsky moment is named after economist Hyman Minsky who said periods of speculation and credit growth inflate assets, only to end in crisis in the years ahead.

It’s a scenario that many think China is destined for, but will those premonitions be replicated in reality?

According to Larry Hu and Jerry Pang, analysts at Macquarie Research, the answer is most likely “no”. They say there’s four key reasons that are often overlooked by China bears.

“For a Minsky moment to happen, a liquidity trigger is needed,” say the pair.

“For instance, China’s banking system used to have 40% NPLs back in the late 1990s. Technically, all China banks at that time should have gone bankrupt and suffered from a bank run by panicking depositors.

“However, this didn’t happen because China banks didn’t have liquidity problem. Depositors continued to put money in banks, as they trusted banks which were backed by the government.

“As such, banks could still function even if they are insolvent.”

Hu and Pang also note that China’s financial system, compared to other major economies, is significantly less complex.

“China’s financial system is not a very exciting one,” they say. “The majority of credit in China is backed by sticky bank deposits, not volatile wholesale funds. Only 14% of China’s debt is funded by shadow banking lending.

“China’s shadow banking is also boring in the sense that over 70% of wealth management products are used in buying plain vanilla bonds or simply put in banks as deposits.

“Complicated financial products are rare in China.”

As the chart below shows, the savings ratio in China is massive compared to other advanced economies.

In the instance of a Minsky moment potentially forming, something that Hu and Pang do not foresee, they suggest that government and the People’s Bank of China, the nation’s central bank, are in a unique position that should allow them to address the threat posed to the financial system.

“If a Minsky Moment does appear and a run in the interbank market happens, the intervention from the government is the key to serve as circuit breakers to stop the downward spiral movement of asset prices,” they say.

“After all, a fiat central bank would never run into a liquid funding problem as it could print money as much as it wants. In China’s case, without the need to get approval from the Congress, the intervention from the government could be more timely than in most market economies.”

Even before that scenario occurs, Hu and Pang note that there are other options available to policymakers, including injecting trillions of yuan into the financial system.

“The Chinese government borrows not for income redistribution, but for investment. As the result, the government owns a large amount of valuable assets and it could sell some of assets if it needs to recapitalize banks,” they suggest.

“Before that, the PBoC could first release RMB21tn liquid funding to the banking system by lowering the current 17% reserve requirement ratio (RRR).”

Clearly a lot of firepower, even before policymakers consider asset sales to avert an even deeper financial crisis.

So if a Minsky moment is to be avoided, what scenario do Hu and Pang see playing out? They see two possible outcomes, although they admit that neither option will be particularly palatable, or easy to achieve.

“The government might have to do debt restructuring to lower the interest payment by SOEs. For certain banks with liquid funding problems, most likely the government would issue bonds or simply print money to inject to them. Money printing might increase inflation or currency depreciation pressure. If so, the government needs to raise tax or sell assets,” they note.

“It’s definitely not a pleasant scenario, but still a far cry from a crisis one.

“If it happens, China’s leaders will have to live with lower growth, or a so-called middle income trap.”

The alternate scenario, in their opinion, is something that markets have heard a lot about recently without seeing any implementation: reform of the nation’s state-owned enterprises (SOEs), described by the pair as the “positive” outcome.

To make the transition smooth, certain parts of the economy such as consumers and private corporate might leverage up while the SOE sector deleverages. In this way, the allocation of capital could be improved.

Between central and local governments, the central government might need to take on more responsibility, shifting some of the local government debt to its own balance sheet.

Hu and Pang also believe that in conjunction with reforming SOEs, policymakers should also overhaul the nation’s financial system to make asset allocation more efficient that what is currently the case.

“The share of equity financing needs to be higher and the share of debt financing should be lowered,” they say.

“Ultimately, it needs to overhaul the state capitalism system, so that the potential from the private sector and urbanization could be unleashed.

“By removing the forces which artificially boosts savings and suppress consumption, it could also overcome the major barrier for the economy to rebalance itself.”

Sounds easy in practice. However, in reality, it’s unlikely to be the case, with plenty of opportunities for policy missteps that could roil not only the Chinese but global economy.

Hu and Pang make a solid case, but it’s unlikely to be enough to convince those who believe that bad times lie ahead for the Chinese economy.

History has demonstrated time and time again that an increase in credit growth of this magnitude has always ended in a banking crisis, creating turmoil in the broader economy.

Whether China will be different just because it’s largely a closed financial system will be the US$10 trillion question.

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