Even recently Goldman Sachs, who is typically one of the biggest China bulls on many levels, has raised the specter of whether a financial crisis could envelope China. Last week we covered some of the weaknesses in the bear case that a financial crisis will happen, this time I’m going to focus on the bull case and its weaknesses.
I want to note a couple of things that are most likely my personal biases. First, I tend to think that bears overestimate the probability of a crisis while bulls underestimate the probability of a crisis. In probability-speak, you would have something like a lumpy extreme bimodal distribution. Second, while I do not think a crisis is inevitable or that the bears have an ironclad case, I do believe the weight of evidence leads to much more pessimistic outcomes than bears can make a strong case for.
Third, extrapolating on the previous point, the most likely scenarios moving forward, lead much easier to more pessimistic scenarios even if not a full blown crisis. By that I mean, absent major policy changes, it is much easier to see bull and bear cases leading to more pessimistic scenarios than positive outcomes. For instance, if China decide to deleverage an in 2017 held fast to a mandate of zero credit growth, that would result major negative pressures likely resulting in at best low single digit growth.
China will grow its way out of its problems. This is probably the most widely used argument by bulls and in reality underpins pretty much every argument made by China bulls. This is both entirely accurate and an entirely false sense of security. Let me explain.
First, many like to cite China’s high growth rate as proof that it remains robust but fail to look at the relative rate of growth. From 2002 to 2016, nominal GDP growth was an annualized 13.8%. From 2009 to 2016 it was 11.4%. That is very good but does not explain the problems China faces entering 2017 and why we are discussing whether China will have a financial crisis.
What is concerning is the shift in the Chinese economy to one that makes it entirelyreliant on credit growth. From 2002 to 2008, the total stock of social financing grew at an annual rate of 16.9% or slightly less than the 17.5% nominal GDP growth during that same time. From 2009 to 2016, these numbers reversed in a major way. From 2009 to 2016, nominal GDP grew at 11.4% but the stock of total social financing grew at 17.3% or nearly 6% faster than nominal GDP. That basic ratio has held pretty closely even as growth and TSF have moderated slightly in recent years.
The reason I give this as background, rapid growth by itself will not solve China’s problems. Let us take a simple scenario and assume that China continues growing nominal GDP at 7-8% for the foreseeable future. Absent a major and sustained drop in TSF growth, China will eventually have a financial crisis. Citing growth as a reason China will not have a crisis in isolation is no reason at all.
Second, not only is the rate of growth in credit to GDP a problem, the level is now a serious problem which makes this situation much more difficult to reverse even with high growth. Different people and organizations arrive at slightly different numbers but the estimates of China’s debt to GDP is roughly 240-280%. (The South China Morning Post uses 260%). This level makes it very difficult to correct this problem even if the growth rates moderate.
Let’s again take a simple scenario to illustrate the point. For simplicity sake let’s say that China’s debt to GDP is 250% (which I believe to be a very conservative number). What makes this unique is that most of this is held by corporate and household sectors and an increasingly significant share funded by shadow banking. Why that matters is that this implies higher interest carry costs than if it was held by the sovereign. (Let’s ignore for the sake of this exercise the specific nature of China sovereign and SOE’s.). According to WIND, the bank index loan rate on 1-3 year debt is 4.75% so if we factor in the rates from shadow banking and what not, we can safely us 5% as a round number estimate for the debt service cost.
This would imply an annual debt service cost equal to roughly 12.5% of nominal GDP simply to stave off default. By comparison, a like Japan with very high levels of indebtedness face borrowing costs near zero and most held by the sovereign. In fact many highly indebted countries which China compares itself to face much lower finance carry costs. The level of indebtedness, the interest rate differential, and the debt service costs will make addressing this problem increasingly difficult.
Third, the argument that China will continue to grow fast depends almost entirely on rapid expansion of debt and is therefore circular and requires debt to grow to astronomical levels. Let me reframe this question in two ways. What would happen to growth in China if Beijing was worried enough about growth they opted to impose a hard cap of no debt growth and anyone found violating this would be executed and they then got to the end of the year and found that debt had not grown? In a best case scenario, it would likely grow in the low single digits say 1-2%. In reality, you would probably induce a hard landing or recession.
Let’s take another less extreme scenario and assume (hypothetical of course) that China could perfectly predict nominal GDP for the year and set a cap such that credit grew by the exact same amount. For instance, if nominal GDP growth was 6.5% then credit growth would also equal 6.5%. What do we think would be the growth rate in this case? At best, it would likely be in the low to mid single digits say 2-4% but in reality, would probably prompt similar outcomes with a higher probability of a straight out recession rather than a hard landing or financial crisis.
Let’s even take a less extreme scenario with a variant of the above. Now let’s assume that China can perfectly predict the nominal growth rate at the beginning of every year and now applies a rule of credit growth that is equal to the ratio of credit growth of nominal GDP growth minus 10%. For instance, in 2016, TSF growth was 13% and nominal GDP growth was 8% with the ratio of those two numbers being 1.62. If we take away 10% that gives us a number of 1.52. Using this simple rule, it would be 2023 before debt was growing at slower rate than GDP (using some simple static rules). By that point, debt to GDP would be well above 300% quite possibly even 350%. Given this expansion of the credit and money while trying to prop up struggling industry while maintaining a quasi-fixed exchange rate, it would seem likely that Beijing would have to drop the peg. Furthermore, this would imply rising debt to GDP through the early part of the next decade with minimal deleveraging thereafter.
Fourth, one of the most concerning parts of the current debt conundrum is the hubris associated with Chinese policy making and its previous bad debt struggles. More than a decade ago, when China was recapitalizing its banks and creating bad debt asset managers, it effectively outgrew its mountain of bad debt. Though we cannot know for sure, there is strong evidence that a not insignificant amount of this debt was never written off but just sat idle for years the nominal GDP growth outpaced debt growth. In 2014, you had banks going public with decade old bad debt that they were using IPO proceeds to pay off the asset manager who bought their bad debt.
Though I have never seen it explicitly or implicitly stated, my personal strong belief is that China is hoping to grow its way out of its debt mess the same way it did previously. For reasons that would occupy another blog post if not book, that period in Chinese and even global history was such a unique period that is unlikely to be repeated and produce growth rates that will repeat this outgrowth phenomena.
Nor can we overlook the law of large number China edition role in this outgrow scenario. The surpluses that China ran from approximately 2000-2010 were enormous in relative terms. To run similar sized surpluses would result in surpluses of mind boggling size that would result in unparalleled distortions. They simply will not be returning.
Even with sustained growth, it remains highly unlikely that growth will prevent China from having a crisis. Other factors may but the single minded bull focus on growth seems rather misguided.