Crisis or Stagnation: Why China Cannot Deleverage
The latest figures of the Chinese economy show a third quarter GDP growth of 6.8%, suspiciously in line with the government mandate and consensus estimates. However, it is not the top line that worries me. It is the evidence of debt saturation and diminishing returns of the central-planned model.
Chinese total debt has surpassed 300%. In the first nine months of the year, money supply has increased by 9.2%, significantly above estimates.
China has added more debt in the first nine months of 2017 than the US, Japan and the EU combined.
The private sector debt increase is a major concern. The vast majority of the largest quoted companies (c60% of the Hang Seng Index) have published results with returns significantly below their cost of capital, looking at Bloomberg figures. According to the Financial Times, zombie firms have soared as growth fails to catch up debt and interest increases. Additionally, in a situation that mirrors the reckless international buying spree of European conglomerates in the early 2000s, the results of foreign capital investments at ludcrously high multiples have generated a backlash for Chinese multinationals. The central government’s legion of zombie firms (those unable to cover interest expense with operating profits), is comprised of 2,041 large companies with assets worth some $450bn.
The concerns over the mountain of debt is only comparable to the atrocious returns in a fast growing economy. A glance at the Hang Seng Index shows a leverage of 122% (total debt to equity) and 17.5x debt to assets, with an abismal return on assets of 1.33% and return on capital of 4.5%.
It does not improve significantly by sectors. Even if we look at what has been optimistically called “new economy”, Chinese companies boost a similar combination of weak fundamentals and poor capital allocation. The “new economy”, driven by high productivity sectors, is heavily dependent on strong capital markets in order to finance growth via bonds and equities. A surprisingly low non-performig loanb ratio of 1.74% is widely questioned, and Fitch, for example, estimates that the real figure is ten times greater than the official one. A weaker stock market and contagion effect of rising non-performing loans impacts the weak and obsolete dinosaurs and the nascent, thriving sectors alike. We saw it in Taiwan, Japan, and the EU.
Can you imagine what would happen to these extremely low returns if growth was reduced to a more sustainable 4%? A complete collapse of the economy. This is one of the reasons why -despite public messages suggesting the opposite- the government cannot and will not likely put deleverage as a priority.
“China requires 6.5 units of capital to create one unit of gross domestic product growth, double the ratio of a decade ago”, according to UBS and the Financial Times.
The situation worsens with households. Household debt to GDP has multiplied by four in the past ten years. China, once supported by strong household savings, is on a debt binge that, by 2020, where the ratio of mortgage payments and disposable incomes in China will match the peak level in the US before the financial crisis.
This is the second reason why China cannot put deleverage as a priority. The Chinese economy is unable to tackle a social crisis if house prices moderate -let alone fall-, pricking the housing bubble. China does not have a welfare system that allows a social cushion if a domino of bankruptcies happens in the household sector, and the social crisis would be unmanageable.
These factors make China’s mirage of deleveraging impossible. At best, we will see a monster increase in public debt when the private sector stops its “running-to-stand-still” strategy. However, public debt is not small. The “optically” low level of 46.2% has to add the public sector companies, which puts public sector liabilities at close to double the official debt to GDP figure.
China has few options. Most of these imbalances and liabilities are financed in local currency with local banks, and the government could devalue the currency drastically, but that would hurt its economic growth, sending a questionably low inflation (also estimated to be three times higher than official rates) to socially unacceptable levels. China also has a strong saving ratio, at 39%, but the myth of the country’s high savings is debuked by the extent of its debt and the link to speculative bubbles and poor returns. If China decides to tackle its imbalances tapping into those savings through financial repression -like Japan did-, it would massively impact its growth, consumption and send the country to stagnation.
And that is the positive outcome. China can endure the end of its vicious circle of poor capital allocation, high debt and rising imbalances through stagnation avoiding a social collapse and massively increasing public debt. But that is all it can do. If it wants to avoid a giant financial crisis that would clean the system and resume sustainable growth, but at the same time create significant social challenges, it will have to accept high-debt-zombified stagnation the way that Europe, Brazil or Japan ended. There is no magic solution that will sort these enormous imbalances while delivering world- leading growth.