In my previous article on Japan’s debt problem, I wondered at the way the Land of the Rising Sun has been able to accumulate a staggering amount of liabilities with virtually no challenges, until very recently, from the investment community.
The opposite case can be said about China, as a notable trend in the financial & investment discourse over the last few years has been the call for a “China crash.” A number of prominent investors and media pundits call it “the mother of all bubbles” and anticipate a crash for the Middle Kingdom like Japan circa-1990.
As the readers of my commentaries already know, I disagree with the above assessment: while its economy is likely to experience soft patches along the way, China is on a solid long-term footing and will continue to experience strong growth for years to come driven by secular fundamentals.
Perhaps China bears have been overly biased by China’s past rather than on current economic fundamentals. As an investor with fifteen years on the ground in Asia, countless meetings and business deals in China, not to mention a genuine passion for the country’s rich history and culture, I may benefit from a closer point of view than a Connecticut or London-based hedge manager who goes to China once a year and relies largely on second-hand information.
After a brief analysis of the fundamentals, I review some of the dynamic factors that support the ongoing success of the “China Story,” and close with a couple of possible scenarios.
There is no argument when it comes to China’s success story over the last 20-five years. In fact, when seen through the lens of history, it should not be surprising that China has reclaimed its role as world super-power, a role the country played for the vast majority of its two-thousand years existence.
When it comes to the actual figures however, many analysts cry foul as the quality of Chinese official data frequently appears unreliable. There is some truth to the claim, yet it is important to understand that such inaccuracy is not deliberate but rather part and parcel of China’s culture and the relationship dynamic between central and local governments. Furthermore, it is a problem for China’s government as well, and there is a genuine commitment to improve the accuracy of economic data which is seen as critical to both business and policy makers.
Let’s review the most common arguments used to support the thesis of the upcoming China “crash”:
1. The official data on public debt doesn’t include the large obligations Provincial and Municipal governments have taken on via off-balance sheets vehicles.
2. The banking system is saddled with massive NPL (Non-Performing Loans) which are not booked as such due to their political sensitivity.
3. The country is dotted with “ghost cities” and other infrastructure that has yet to show any economic justification. Sooner or later these losses will have to be booked, the country will suffer a Japan-like collapse.
The common denominator to the three issues is the conviction that a large bill is looming and that once the tab comes up, China’s lender of last resort will have to step in and pick-up the pieces, hence the belief that the country’s official data grossly underestimate the outstanding debt in the system.
A basic analysis of the data should help to put the issue into context:
According to the IMF, China’s GDP is $6 trillion with an “official” 2010 sovereign-debt to GDP ratio of 19%. According to the PBOC, the total amount of non-government debt outstanding in 2011 is about $7.5 trillion. These figures appear fairly reliable considering the following:
1. Adding government debt, the total debt/GDP ratio would be about 144% and fairly comparable with similar economies such as Brazil (142%) or India (123%)
2. The chances of a credit event of any material magnitude not being reported is extremely unlikely as financial activities in China are strictly monitored and regulated.
3. As the PBOC figures include the entire banking sector together with the debt assumed by local government and state-owned enterprises through private financing vehicles. By definition, it also includes any infrastructure or property-related debt.
Let’s now assume, that a staggering 25% of total debt outstanding is “non-performing”. Bear in mind that in the case of Spain and Greece, for example, the same for 2010 was respectively 6% and 10% of total loans outstanding. If we assume such NPL will eventually default and end up on the government’s ledger, we get liabilities of about $2.3 trillion and a revised debt/GDP ratio of 51%. While the debt load would be still manageable, it does not yet represent the true fiscal position of the country once currency and gold reserves (worth $3.1 trillion) are factored in. The adjusted total debt/GDP ratio gets to (negative!) -2.0%. Even assuming a “stress case” with “hidden” liabilities amounting to 50% of total debt outstanding, we would get to $4.8 trillion or an 82% debt/GDP ratio. Once reserves are factored in, the adjusted debt to GDP ratio is less than 30%, a very low ratio by any standard and, even for such an extreme scenario, hardly a critical concern for the country’s fiscal health.
Below a table to recap:
Moreover, on a qualitative basis, a country growing 9.5% p.a., or even a reduced 6% p.a., has a debt capacity far higher than the 30% debt/GDP “worse case” scenario. In fact, as a certain degree of leverage is required for corporations to fully unfold their potential return to shareholders, the same can be said for countries. A case in point is the US during the 1950s and 60s when the debt to GDP ratio was below 40%, and shrinking at a rapid pace when the US launched a series of spending efforts including the Space Program.
Lastly, the above analysis does not even start to contemplate the possibility of the RMB becoming an international currency reserve and the Chinese government starting to issue “C-Bonds” on the international markets (an asset class that may find a very warm welcome among global investors as a way to diversify away from US T-Bonds).
The China Difference
Any serious scenario analysis involving China has to be mindful of certain factors that set the country apart from any other major economy. Those factors are structural in nature and likely to play a role for years, if not decades, to come. As China continues to develop, the key engines that will support economic growth:
1. Whereas the backbone of advanced economies is represented by domestic consumption for goods and services of around 60-70%, in China such component of the economy demand is around 40%. The spending for health care is an excellent example; while the OECD average is about 9% (17% in US), health care in China is only 5.8% of GDP. The natural growth of consumer spending as a component of GDP will provide tremendous fundamental growth.
2. While the Western countries struggle with the “dual mandate” of inflation and unemployment, “和谐” or “harmony” is the imperative in China’s policy. The government is acutely aware of the risks that economic disparity may have on social order, as 20-five years of rapid economic growth have created a great deal of unbalances. And Chinese politicians are steeped in the thousand-years old belief that a government retains its “mandate from Heaven” only as long it ensures an harmonious society.
3. Unless there is an unlikely political upheaval, China is likely to become a bigger and bigger magnet for investors both domestic and international. Already the largest recipient of Foreign Direct Investment after the US, the very high domestic saving rates, together with the development of the local financial markets, will foster greater inflow of capital from domestic investors as well.
4. Last but not least, after capitalising for years on its labour cost advantage, China is determined to become a major source of innovation. The key drivers are the large and increasingly educated population, the culturally profound respect for learning, and also the need to find local solutions to pressing challenges such as energy, the environment, health care and food production. Innovation will foster increasing economic growth through productivity gains and export of technology.
While short-changing China would be a mistake of historical proportions, it would also be naive to expect its growth to continue in a linear fashion; China is overdue for a slow down which may be coming sooner than later.
The one problem the Chinese government cannot tolerate is excessive inflation because of its potential to inflame unrest. While the latest official Inflation data is 5-6%, anecdotal evidence points toward far higher increases, especially in the coastal cities. Of particular concern is food price inflation which is in double digits and is particularly harsh on lower income segments of the population.
While the authorities have adopted a multi-prong approach against inflation, including currency appreciation and repeated rate increases, the trillion dollar question is whether those efforts will cause a “hard” rather than “soft” landing for the economy. There is indeed the possibility of a “hard landing” should policy “overshoot” and annual growth slows to below 6%. Even in the worst case scenario the combination of fundamentals and fiscal health should provide China the ability to adjust its course and resume its “long march” to a modern and very prosperous society.
China’s strong fundamentals and domestic markets should provide the country with some insulation from the vagaries of global financial instability. Yet, the opposite may be true and a significant China slowdown may end up playing a major role in destabilizing an already frail global economy. More specifically, a China “hard landing” may have chilling consequences across a number of markets:
1. Commodities: China’s demand is universally credited for driving prices of most natural resources both in terms of spot prices and derivatives.
2. Currencies: China’s demand of USD has been a critical support to the greenback for decades as exports are priced in dollars and a large amount of those have been used by China to purchase US Treasuries. Moreover the import of commodities from Australia and Brazil have also provided key support to those countries and their respective currencies.
3. Asia Region: China’s demand has been playing a critical role in the economies of most countries in the Asia Pacific region including Australia and Japan. Should China hit a soft patch, the repercussions on markets such as Taiwan, Korea or Hong Kong could be very recessive.
In conclusion, the concern about a China “bubble” bursting under the weight of massive debt appears to be overstated. Furthermore, whilst a China slowdown appears likely and the repercussions on global markets may be very material, the long-term future of the Middle Kingdom continues to appear bright as supported by strong secular fundamentals.
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