China deleveraging - How concerning is the issue?
By Aravindan Jegannathan CFA, Senior Analyst, JK Capital Management Ltd., a La Française affiliate
China debt to GDP surged from 162% in 2008 to 265% as at the end of December 2017. The pace of increase in the level of debt to GDP ratio slowed in 2017 to 743bps yoy compared with the past three years’ average of 1345bps1. The Chinese government aims to improve the debt to GDP ratio by growing the debt at a rate that is slower than the rate of growth in GDP (i.e. approximately 6.5% as officially expected2).
Currently, the concerns about China deleveraging have died down due to the improvement in the financial health of State –Owned Enterprises (SOE) which account for a significant portion of China’s debt burden. SOEs witnessed a strong recovery in producer prices in 2017 due to the ongoing supply side reforms that resulted in an improvement in their Return on Assets in 2017. The number of companies that witnessed credit upgrades in the past year exceeded downgrades indicating an improved financial health for Chinese SOE corporates. As a result, the urgency for SOEs to bring down leverage has decreased.
A couple of years ago, the market remained paranoid about China’s alarmingly high debt levels combined with low return ratios for SOEs. A large portion of investors were also skeptical about the ratio being understated and envisioned that a high leverage ratio and high Non Performing Loans ratio would engulf the entire banking system like a contagion. However, we have been witnessing a quarter on quarter improvement in asset quality both in terms of ratio and absolute level of bad credit over the past few quarters. At the moment, China seems to have come out of the concerns of a debt contagion.
One can also argue that China’s debt problem is not the result of mismanagement of affairs but has more to do with the government’s planned deployment of capital to maintain GDP growth at desired levels. We believe China’s capital intensity is slowing down and the leadership is well aware of the debt problem, having exhibited strong control over it. The market is also mindful of this fact as witnessed from China’s credit rating which stands at A1 for Moody’s, a significantly higher rating than other countries in the region with lower leverage ratios. With China’s low interest rate environment and low reliance on external debt (less than 5% of total debt) amidst high savings rate, the debt to GDP ratio should not be looked at in isolation.
To conclude, deleveraging remains a long-term goal. China’s Debt to GDP ratio should be read in conjunction with the country’s low interest rate, low external debt to GDP ratio, high domestic savings rate and high forex reserves. While it is in the best interest of the economy to deleverage, it will be gradual with a slower increase in the debt to GDP ratio to be expected over the coming years as already witnessed in 2017. As part of deleveraging, China’s Central bank PBoC is rightfully focusing on clamping down shadow banking to first understand where credit lies while addressing the problem of excess leverage in the economy. Deleveraging should be interpreted within the current growth context. Once the government witnesses a slowdown in growth, we believe deleveraging will slow down until growth concerns abate. Economic growth is critical for deleveraging to sustain as we believe a marked slowdown in GDP growth would magnify the debt concerns of the country.
1 Source: Bloomberg: CHBGDTOP Index
2 Source: National People’s Congress, 2018; https://www.ft.com/content/3cc9e6d8-2044-11e8-a895-1ba1f72c2c11
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