Enodo Untangled
- China is in the midst of a slow-motion real economy crisis
- A banking crisis is unlikely, but new “bad bank” asset measures to come soon
- Further old-style stimulus likely to achieve stabilisation at best
- Consumers dead in the water amid Xi's assault on materialism
- If Beijing sparks a stock market recovery, consumer sentiment may improve
- But debt-deflation and decoupling makes liquidity support to equities unlikely
- Yuan devaluation will be a last resort, but creeping capital controls a concern
The economic policymaking season is about to kick off in China, making the rest of the year pivotal if the country is to shake off its economic malaise and avoid sinking deeper in deflation.
Investor confidence in China’s economy and markets is already low. It could sink further if policymakers do not come up with a convincing plan of dealing with mounting bad debts, as well as shoring up battered consumer and entrepreneurial sentiment.
In coming weeks the Party’s Central Committee is set to meet for its Third Plenum, a gathering traditionally focused on making big decisions about the economy. The National Financial Work Conference, a once every five years financial policy event, will convene next week and the Central Economic Work Conference, which lays out the priorities for next year, will follow in December.
If Beijing wants to stabilise the economy it will need to act decisively now.
There are indications that more support measures will already be forthcoming in October, likely after the upcoming State Council meeting and/or the Politburo meeting at the end of the month.
Let’s take a look at China’s key challenges in boosting growth, Beijing’s likely policy responses and the authorities’ chances of success.
Key Challenges
Debt-deflation
Whether an economy has become over-leveraged is a matter of judgement rather than a precise formula.
Our assessment is that China has now borrowed too much. The necessary debt clean-up will be difficult and deflationary.
China’s non-financial non-government debt is now in uncharted territory when compared to Japan’s experience during its excess debt era, before that country plunged into its “lost decade” of stagnation. And China’s debt level relative to GDP is still rising.
We estimate likely credit losses in 2023 to be between 37% and 42% of GDP – a staggering number.
Contrary to popular perceptions China is already in deflation as measured by the GDP deflator, which is a better gauge than consumer (flat) or producer (already contracting) prices. The GDP deflator contracted in both Q2 and Q3 this year. It has been in negative territory for two consecutive quarters only three times in the past – during the Asian Financial Crisis, the Global Financial Crisis (GFC) and in 2015.
Over-investment
China has over-invested for nearly two decades. Being generous in our assumptions, we estimate its sustainable rate of investment to be – at most – 35% of GDP. Before the GFC Beijing was able to ramp up investment because its exports were grabbing a greater share of the global market, allowing it to apply excess export profit to investment.
But in recent years, it could no longer throw money at unproductive investments, as it did in the immediate aftermath of the crisis, without the fast accumulation of debt.
A few years after their post-GFC splurge, Chinese authorities tried to restrain the increase in capex, but when the economy tanked in 2015 they resorted to investment to boost growth again. They also began to de-risk the financial sector and managed to level off the ratio of non-government, non-financial debt to GDP.
After its initial success at containing the spread of Covid, Beijing introduced regulatory restrictions on borrowing by developers – the so-called “three red lines” – in 2020 while Xi Jinping doubled down on his mantra that “houses are for living in, not for speculation”.
As a result, real estate development loans and mortgage borrowing tanked. Worried about the economic downturn that resulted from the zero-Covid policy, the authorities yet again resorted to old-style growth, channelling more credit and investment into heavy industry and services.
But China has now reached the end of the road of its investment binge as return on capital has plummeted.
Over the next decade, capital stock is likely to make a minimal contribution at best to China’s potential growth rate, if it doesn’t become an outright drag on growth.
Downbeat consumers and private entrepreneurs
Xi Jinping’s watchword is frugality. Even more importantly, he is determined to address China’s gaping inequality. To narrow the gap between rich and poor, he seeks to reverse excessive income accumulation and stop house price inflation. Property is the main asset for middle-class Chinese families. In cities, families hold apartments for capital gains, not for rental income, as the rental market is underdeveloped.
Households lack income from their investment properties, and they can no longer rely on capital gains to grow their wealth. This fundamental change has altered the incentives of many well-off and middle-class urbanites, pushing Chinese households to save even more.
China’s goal of rebalancing its economy towards consumer spending is dead in the water. Analysts welcomed stronger retail sales data in September, but our estimates for retail sales volumes show slowing momentum in Q3.
Xi’s other ideological goal is to strengthen Party power in both state-owned and strategically important private enterprises, and to subordinate business decisions to the needs of the Party. Over the past few years, Xi has clamped down on big private sector companies, which he regards as a threat to the Party’s monopoly on power, in addition to hoarding the nation’s wealth and valuable data.
True, part of the “common prosperity” described by Xi is to create space for small and medium-sized enterprises (SMEs), which account for 80% of urban employment, and encourage them to get rich through hard work and innovation.
But ultimately, why would business owners want to succeed when they have little latitude on how to spend their money, and when hard-earned gains could be taken away to serve the needs of the Party?
In any case, the strategy has not worked so far. It has plunged the economy into the doldrums and causing policymakers to reverse gears.
Weak global demand and decoupling
As China’s economy suffers and discontent among China’s Party elite grows, Xi has softened his attitude towards the US. He is making nice with the Western powers in order to reduce the pace of foreign firms leaving China and to prevent China from being cut off from key Western technology.
Neither the US nor China are under any illusion that a genuine improvement in relations is feasible. They are purely seeking to put a temporary floor under its relentless deterioration.
While decoupling as a secular trend is here to stay, China also faces major external cyclical headwinds. European and US monetary developments point to stagnation (at best) in those economies next year, so Beijing cannot expect an outside demand boost.
Beijing’s likely solutions
The Chinese Communist Party is loathe to throw a huge monetary stimulus at its ailing economy. It worries the result will be inflation rather than a sustainable boost to growth, unless productivity growth improves.
High inflation is the only economic force the Party really fears because it affects everyone, can’t be hidden with propaganda and has always, in the past, been associated with social unrest.
Beijing continues to stress the need for quality growth rather than quantity. But the leadership is also disconcerted by the economic downturn and the lacklustre impact of the support measures it has already adopted.
Over the past few months Xi Jinping has pulled together his new economic team, which boasts deep expertise in dealing with local governments and debt issues. The leadership has also been more open to canvassing expert and academic opinion more broadly.
They appear to be gearing up to deal with China’s debt problems and the malaise infecting its “animal spirits”.
Below we discuss the policy levers they are likely to pull and the measures they are likely to adopt to bring the economy on a more stable footing in coming quarters.
Working out the bad debt
Back in 2015-16 we were worried by the pace of increase in the ratio of China's non-financial non-government debt to GDP, but saw ample fiscal scope for Beijing to absorb the credit losses. This is no longer the case.
China’s government debt rose to 79.4% of GDP in Q1 2023, up from 71% in Q3 2022 and just 42% at the end of 2015. Its government debt ratio is now higher than that in the US, EU and the UK when the GFC hit and lower only than Japan’s.
China has a big solvency problem, but it is unlikely to have a liquidity crisis. Because the bulk of debt is domestic, the banking system is state-owned and capital flows are controlled, inter-bank liquidity crunches or widespread classic bank runs are unlikely to take hold.
While we think a banking crisis is unlikely, China is in the midst of a slow-motion real economy crisis.
Beijing is used to cleaning up bad debt periodically. Its first priority is to get to the bottom of what the real debt burden is, as it did in 2013 when it first tackled its local government credit problems. It has also been successful in the past at separating out “bad” banks from “good” banks as it did in the late 1990s when it set up asset management companies (AMC) for the bad debts of each of the big four banks; in 2014 it approved the creation of local AMCs. Beijing has form on how to roll over debt by extending the duration and lowering the cost, as it did during “Operation Twist” in 2015.
Defusing China's Local Government Debt Bomb 2011-2016
But in the past, shuffling credit around and sweeping it under the carpet worked without the need for major structural changes because Beijing could rely on strong growth (especially due to its entry to the WTO) to shrink the bad debts away.
China can no longer expect that a robust economic expansion will help it outgrow its bad debt problem. Years of wasteful investment have finally come to haunt it.
Even so, as Beijing starts another round of comprehensive clean-up using the same methods as before, investors are likely to respond positively – at least initially.
More old-style credit-fueled investment
Beijing is likely to continue to boost public sector investment – both in infrastructure and new technologies – to offset slumping private sector investment, especially in real estate, and meagre consumer spending growth.
But increasingly the central authorities will need to step in, even if reluctantly, given decimated local government finances.
Last year, policy banks stepped up, providing infrastructure projects with Rmb750bn in seed capital. Infrastructure projects require capital equivalent to 20% of total planned investment before they can borrow. Local governments have traditionally provided the capital but increasingly lack the funds.
As expected, the authorities will resort to the issuance of special treasury bonds in Q4, which helps keep spending off balance sheet, as they have done before. But this is unlikely to be enough given the scale of the financing needed.
Therefore, we expect a higher budget deficit target next year after the upward revision to 3.8% of GDP for this year’s target.
Boosting consumer borrowing
While local governments and non-financial firms in China are overextended, households are not -- not yet. Beijing is trying to boost mortgage borrowing growth by lowering costs and removing restrictions, but urbanites who do not yet see a bottom under house prices remain far from enthusiastic about plunging back into the housing market.
Structurally, mortgage borrowing, which is typically the safest type of bank lending, has scope to expand further to reach US levels. But if China were to rely solely on this last remaining source of private-sector leverage, it would only be able to achieve a temporary boost to growth.
Fiscal transfers
The authorities are also likely to continue to resort to fiscal transfers in order to prop up consumer incomes by redistributing income from the rich to the poor, but this is not an efficient way of distributing resources. Moreover, consumers could choose to save the extra income rather than spend it. China’s already exorbitant household savings rate has gone even higher as uncertainty and gloom have gripped consumers.
Some analysts argue that the excess savings represent pent-up spending but fail to point out what is likely to cause households to save less and spend more in the immediate future. The top leadership is unlikely to abandon its mantra that “houses are for living in, not for speculation” or raise deposit rates in order to boost household interest income. Chinese households are net savers.
Equity market support
With direct equity holdings at 52% of household financial assets, successful efforts by the authorities to boost the stock market could precipitate less household caution and unzip household purses. Beijing has been trying to support the equity market with various measures but has so far failed to lift prices.
Broad money growth has started to slow in recent months and the authorities are now mulling over setting up a stabilisation fund to invest in equities, urging SoEs to continue to buy back more of their stock and increase dividend payouts. If the authorities succeed in lifting the equity market and sustain a rally over the coming quarters this could potentially buoy household sentiment.
Capital controls
Beijing is loathe to devalue its currency in order to cushion the painful adjustment that China is going through. In the context of weak global demand it may not achieve much bang for its buck. But more importantly the Party has spent nearly three decades trying to present the yuan as a stable currency and a credible alternative to the dollar to its Asian trading partners. Now more than ever it does not want to jeopardise these efforts.
Beijing has sizable foreign exchange reserves but there is a limit to how much it can defend the yuan if downward pressure intensifies. As a first line of defence, the authorities have been tightening capital controls over the past two years and are likely to ramp up their efforts further.
This does not bode well for Western investors, especially foreign direct investors, despite Beijing’s repeated efforts to reassure them that China is open for business.
Put a floor under the deterioration in Sino-US relations
Xi Jinping now seems to be entertaining a softer approach to the US. He has ramped up communication with Washington and is likely to attend the APEC summit in the US in November, where he may hold a mini-summit with President Joe Biden.
Xi is hoping that this can help dissuade foreign firms from leaving China and even entice more foreign investment back in.
However, any improvement in the US-Sino relations is at best a minor pause in the intensifying all-out confrontation between the existing and the aspiring hegemon.
Conclusion
China needs the centre of its economic activity to move to consumers but Xi's assault on materialism is far from fertile ground for consumption to flourish. Redistributing income from the rich to the poor could only work if the boost to the incomes and spending of the poor outweighs the hit to the incomes and spending of the rich. That's not certain at all.
There's some structural scope for consumer borrowing to pick up speed but mortgage demand is likely to recover only when households believe the decline in house prices has bottomed out. Yet at the heart of Xi's common prosperity lies the idea that house price inflation is bad for social equality.
A successful revival of the equity market, if sustained, is the only route to boosting household wealth and income and buoying downtrodden consumers. But the scale of China's debt-deflation problem and continued foreign investor scepticism over the rationale of long-term investing in China make it hard to see where the liquidity support to the equity market will come from.
We have argued for a few months now that Beijing will have to roll out measures to support the economy but they'll have to rely yet again on investment-fuelled growth. The low return on capital suggest at best the authorities could hope for is some stabilisation.
Beijing’s toolbox still includes tools that it has deployed effectively in the past to sweep bad debts under the carpet, but it can no longer count on a booming economy to simply shrink its debts away over time.
A long and painful unwinding of a decade of debt and two decades of mal-investment is ahead for China. We describe this as a slow-motion real economy crisis.
A sharp yuan devaluation is likely to be the last pressure release valve that Beijing would want to turn. Instead, we have become much more concerned that China's tightening of its capital controls could spill over to Western capital, especially direct investments.