The Macro Report | November 2016

Knee deep in debt in China

Emerging markets may be pushed to the precipice by U.S. political change while China’s debt problems continue to grow.

The U.S. presidential election result poses a real challenge for emerging markets (EM) as an asset class. EM economies have grown as globalization has progressed and as capital and goods have flowed more freely across borders. But if the United States becomes a more closed economy, as has been suggested repeatedly through Trump’s campaign, EM will suffer across the board. The violent reaction of Mexican financial markets to the Trump victory is an extreme example, but it is an indication of the type of thing that could happen if Trump follows through on his campaign promises about closing off the United States.

China quietly deals with its U.S. policy risk exposure
Bracketing the U.S. election for the moment, we have observed a continued gentle improvement in the EM cycle, with economic momentum building across a variety of countries. The improvement in some of China’s economic data has been enough to prompt a discussion of further policy tightening there, with some measures aimed at the real estate sector.

But while the data flow has edged up, China’s currency has been edging down. With the market distracted by the U.S. elections, Chinese authorities have guided the yuan lower. As we write, the yuan is down about 3% versus the U.S. dollar from its late January 2016 level, and almost 6.5% lower than a year ago. China is greatly exposed to U.S. policy risk. During his campaign, President-elect Trump repeatedly referred to China as a trade cheat and as a currency manipulator. Whether this is campaign rhetoric or a signal of a genuine change in future policy is something we shall have to watch very carefully.

Debt remains China’s Achilles heel
The central long-term issue in China continues to be the buildup in debt. A recent study by the Bank for International Settlements (BIS) produced a data set that gives us a unique window on this problem. We created the accompanying illustration using BIS data to look at the growth of total credit in China’s economy and to compare it with the growth of the economy as a whole.

When credit is steadily growing faster than GDP — when the “actual” line rises above the “trend” line in our chart — that implies that each incremental unit of credit is generating a smaller and smaller payoff in terms of GDP growth. In other words, the efficiency with which credit is being used must be declining. This in turn suggests that future bad loans are being created at a faster pace than would be the case if credit were growing more slowly.

We can also compare the current “credit-to-GDP gap” in China with the gap in other countries. To clarify, this is not an exercise in comparing credit levels with GDP levels; rather, we find it revealing to compare the size of gaps between a country’s level of credit to GDP and its own national trend. In our analysis, it appears that the current gap in China is at a level that, in other countries, has historically created problems. This does not mean that China is bound to suffer a financial crisis, and it certainly does not tell us anything about the timing of a negative event. But what is unsustainable usually comes to an end.

Chinese politics may amplify debt problems
Unfortunately, we also think that China’s politics interact with these dynamics in an unhelpful way. We agree with the widely held view that, ahead of autumn 2017, when Xi Jinping is expected to be appointed to his second 5-year term, there is every reason to expect policy levers to be deployed to keep the economy on a steady growth path. But there is a growing tension between political imperatives and the economy’s needs. Xi has centralized power, and has resurrected Maoist ideology. The anti-corruption purge has been intended to enhance the Communist Party’s legitimacy, but it has also left local governments nervous, and they are the ones who have to deliver on the economic transformation agenda that the president is pushing. The old smokestack industries that are supposed to give way to the new, service-oriented economy are disproportionately owned by local governments, the Red Army, and the family members of China’s elite. And they are financed by the state-owned banks.

The allocation of losses after a financial crisis is one of the most difficult choices that has to be made, and the difficulty in doing this in Japan, for example, is one reason why Japan’s post-bubble crisis dragged on for so long. In China, we believe it will be the public, in the form of bank depositors, who will be the most vulnerable to losses in any debt-driven financial mess.

We think this is one reason why so much private capital is trying to leave the country. Having said that, we continue to think that China’s limited financial linkages to the rest of the world minimize the risk of a problem in China becoming a global problem. However, the consequences for growth are another matter, as slower GDP growth in China will likely reverberate globally.

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