CHINA’S DELEVERAGING STRATEGY
With its total domestic debt stock hovering at 230% of GDP (high in comparison with emerging market peers), the risk of a domestic debt crisis in China is no longer negligible, especially in the context of financial liberalization that will structurally lift the cost of capital for domestic borrowers across the board. Does China have a credible strategy to avoid this risk? To answer, we examine three salient features of Beijing’s strategy, which has taken shape through key policy meetings and announcements thus far.
Beijing’s tolerance to an economic slowdown is substantial.
What many market commentaries seem to overlook in the Chinese government’s new macroeconomic targets for 2014 is the subtle broadening of thresholds for counter-cyclical policy, from growth to employment. Since the conclusion of the March National People’s Congress, Premier Li Keqiang and other key policymakers have been stressing the latter as a key consideration in their “appropriate zone”-for-growth target. As the labor market is moving toward structural shortage of supply of workers, the government is likely to meet this target easily despite intensifying cyclical headwinds (top chart). After all, the sensitivity of China’s employment to GDP growth tends to be low (due to elevated productivity growth), and over three years the economy has already outperformed the government’s current 5-year growth target (7% for 2011-15). Thus, we believe that progressively slower growth can be tolerated in coming years without employment crossing the threshold, unless a more severe downside risk emerges for the labor market. This warrants caution against excessive stimulus hopes. Keeping growth at 6~7% is the objective, not a return to double digit growth of the 2000s, which should prevent the forming of new credit-driven bubbles.
Reshuffling credit takes precedence over active debt-restructuring.
The government’s calculation seems to be that going for easier reforms such as fiscal centralization, regulatory tightening on non-bank credit, and the selective withdrawal of small lender guarantees will be enough to manage near-term risks. In our judgment, the effort to reshuffle credit into more transparent channels is indeed yielding some good results. Along with the anti-corruption campaign, fiscal reform measures have sharply curtailed local governments’ propensity for projects and led to strong growth in their cash holdings (28% year-on-year). Growth in trust loans, the riskiest segment of “shadow-banking”, has also decelerated (middle chart) as clampdowns on the banking sector’s exposure to questionable credit and bouts of illiquidity last year injected much-needed fear into loan officers. The roll-out of deposit insurance will be helpful in restraining the behavior of wealth management product investors as well. Nevertheless, the government’s reluctance to risk a systemic event will continue to shield economically and politically important state-owned-enterprises, the largest consumers of credit, from defaults. Therefore, any headline-grabbing default should not be viewed as a Lehman-like game changer but as isolated experiments by policymakers. Therefore, systemic risk should remain contained.
Real estate stands at the crosshairs of long-term risk mitigation.
The government’s urbanization and financial liberalization initiatives, in addition to the overall shift toward consumption and higher income growth, provide fundamental risks of an even less controllable bubble in the country’s real estate sector during its transition to open capital account. As a result, the bias of policymakers will be to limit cash flows to this sector whenever appropriate and to keep housing affordability at reasonable level. The added benefit of targeting the sector is its central role in the steady build-up of hot money. Real estate developers have been active in USD debt issuance and possibly in commodity financing (lower chart). From this perspective, RMB volatility almost looks like a macro-prudential measure targeting the sector. All told, we are more upbeat than the consensus about China’s prospects for successful deleveraging. Priorities are right and plans appear credible. This does not change the fact that China remains in a structural economic rebalancing, but with the likely capping of downside tail risks, the deep value in the country’s equities (MSCI China’s forward P/E below 9x) will create attractive trading opportunities when the balance of policy needs tilts toward growth stabilization.