Enodo Insight
- Enodo estimates that credit losses rose to between 37% and 42% of GDP
- Tech, real estate and consumer sectors are hardest-hit
- Still some room for borrowing by central government and households
- But China faces a slow-motion real economy crisis
It's taken a long time, but we are there now. China has reached the end of the road when it comes to its debt-fuelled model.
This does not mean it's about to have a financial crisis, but it does bode ill for long-term growth. As we discussed in "No Minsky Moment, but China’s Economy Faces Its Sternest Test Under Xi Jinping" China is in the grips of a real economy slow-motion crisis.
Following that report, Enodo Economics just updated its 2023 estimate for credit losses with the full set of 2022 data. The numbers are a shocker.
We estimate credit losses at between 37% and 42% of GDP, up from 26%-31% last year. The Party-state faces its biggest clean-up operation in the most challenging of times.
We combine bottom-up analysis of China’s quoted sector loans with a top-down macro evaluation of the returns on credit to estimate expected loan losses following Beijing's post-Global Financial Crisis borrowing binge.
Taking into account 2022 figures for impairment rates, we estimate credit losses based on a conservative benchmark, using the share of loans to firms with an interest coverage ratio of 1.5 times to total loans as well as a less conservative interest coverage ratio of 2 times. You can read up more on our methodology in the Appendix.
Looking at impairment rates by sector, it is noteworthy that IT is the sector most at risk , surpassing real estate whose woes are well understood. This is not only a reflection of the fact that Xi Jinping managed to bring China's tech giants to heel, hurting their bottom line, but also a serious worry for the leadership's technology ambitions for China.
Worryingly, both the consumer staples and consumer discretionary sectors are among the top five with the highest impairment rates.
This is yet more evidence that the Chinese consumer is in the doldrums, and the much needed rebalancing of the economy is dead in the water.
Dealing with China's bad debt is a daunting challenge. It's clear that the return on investment has cratered and further debt-fueled, investment-led expansion is ill-advised. Mortgage borrowing, which as a share of GDP is still somewhat behind US levels, could be expanded sustainably to an extent. Beijing is clearly intent on reducing the burden of mortgage debt while stimulating household borrowing further.
China’s largest banks are preparing to cut interest rates on existing mortgages, so the cost of mortgages has room to come down. But households must see a floor under the decline in house prices to jump back on the borrowing bandwagon. Xi Jinping has vowed to make housing affordable but may find that falling prices are a deterrent, not an incentive, to further house spending.
Government debt has risen over the past few years. There is still scope for the central government to borrow to clean up credit losses as well as increase consumer incomes in order to shake the consumer out of its stupor.
But the sheer size of the likely losses suggests a massive increase is needed. Preferably, China should borrow abroad so its fiscal stimulus is in tandem with a monetary injection.
If the authorities simply redistribute income, without a boost in broad money growth, they will have to ensure that those whose income is boosted have a higher propensity to spend than those whose incomes declines. This is very difficult to do.
The PBoC is considering setting up a special purpose vehicle to provide emergency liquidity to local government financing vehicles, likely to help roll over trillions in existing debt at a lower cost. China has also asked two of the nation’s biggest financial firms to examine the books of Zhongrong International Trust Co., potentially paving the way for a state-led rescue of the troubled shadow lender.
During each period of debt trouble Beijing has found a way to sweep bad credit under the carpet, hoping strong nominal growth will shrink it away over time. But this game is up.
External demand is weak and the great decoupling remains in full swing. Meanwhile, Beijing seems to have run out of ideas how to get consumers going.
Conclusion
Our estimates of China's credit losses in 2023 are staggering, suggesting Beijing has to orchestrate its biggest clean-up to date at a time when it can no longer rely on strong growth. Its growth engine is sputtering and the only hope for China is to engineer a substantial boost to productivity growth.
Over the past few years, Beijing has focused on a range of supply-side transformations which hold some promise, but whose fruits cannot come soon enough.
For now, we do not see much evidence that China can sustain decent long-term growth.
Appendix
Enodo Economics Methodology for Estimating Credit Losses
There are five steps to our methodology.
First, we estimate the average GDP return on credit over the period 1985 to 2004. We chose 2004 rather than 2008 as the cut-off point because on our estimates that was when China’s overinvestment started. The return on credit was 0.80, meaning one additional dollar of credit boosted GDP by 80 cents.
Second, we calculate the implied amount of credit used to generate GDP in 2005 to mid-2023 at a return of 0.80.
Third, we compare the actual amount of credit with the implied amount of credit in that period. The difference is how much credit is potentially unproductive.
Fourth, we apply an impairment rate to the estimated total of unproductive credit to obtain the amount of bad debt. The impairment rate is calculated using firm-level data from Wind for China’s quoted sectors in 2022. It is defined as the share of loans to firms with an interest coverage ratio of 1.5 times to total loans. The interest coverage ratio is earnings before interest and tax divided by interest payments. This proxy for the impairment rate comes out at 20%.
Fifth, the total of impaired credit is multiplied by a loss ratio. Conservatively, the ratio we use is the cash recovery rate of 0.2 based on available CEIC data on China’s asset management companies.