Prepare for the cyclical credit crunch creeping up on China
Growth has been fuelled by easy access to debt, but rising interest rates portend a reckoning, writes Pieter Hundersmarck
Few countries graduate from the investment-defined categories of frontier, emerging and developed economies — Japan and South Korea being notable exceptions. However, with an economy surpassing the US in size when measured on purchasing power parity, and with wealth per capita growing swiftly, it isn’t far-fetched to say China is on the path to graduating from emerging market status in the not too distant future.
Focusing for a moment on the near term, rising interest rates present a hiccup in this growth path, especially when one looks at the role of credit in the pace of China’s rise. To skip forward to the conclusion, the almost linear growth that China has enjoyed since the 1990s will, to any but the most optimistic commentator, come at the cost of a banking crisis somewhere down the line. Rising interest rates and a decline in global growth could bring this reckoning even closer.
Extending credit is all too easy; getting out of the habit rather more difficult. This is especially true when the credit growth in an economy has been as rampant as in China. As of early 2018, according to Bloomberg, the value of Chinese commercial banking assets exceeded 50% of world GDP by value. This compares to two other large countries by banking assets; the US and Japan, which sit at 22% and 13%, respectively.
This is high by relative standards, as well as relative to history. At their peak American banking assets never exceeded 32% of world GDP. These numbers are of similar magnitude when compared to each country’s GDP (rather than the global number used in this analysis).
WE WILL CERTAINLY SEE THE IMPACT OF UNPRODUCTIVE CREDIT IN THE CHINESE ECONOMY … BANKRUPTCY …
The size and use of credit in China — and where it sits in the economy — has concerned many a China observer. Setting aside for a moment the likelihood, after such an enormous expansion, that much of this credit has been poorly deployed, deleveraging from this high level is especially difficult within the intricacies of a centrally planned economy that has had success in promoting investment through credit growth.
It is important to note that the Chinese economy has been investment-driven for many years, with a well-publicised high investment to GDP ratio driven by elevated property, steel and industrial output. Chinese municipalities and regions, like divisions in a business, have growth targets to hit. Likening the availability of credit to a punch bowl that allows these growth targets to be hit, one would suspect any lack of punch makes the party’s target more difficult to reach.
Even if the government succeeds in its attempt to drive investment output using less credit, it will still need to effectively control consumer credit too. This is on the rise — albeit from historically low levels. It is a tricky balance to strike.
The balancing act is further exacerbated by rising global interest rates and their dampening effect on global growth. With thriving local investment driven by unlimited amounts of cheap credit and capital controls, China has had little need to worry about returns elsewhere in the world. As interest rates rise globally, declining local Chinese investment opportunities, and an already large money supply, could drive money out of China or lead to asset price deflation locally, or both.
To the two certainties in life — death and taxes — one should add one other: the inexorable truth of economic cyclicality. We will certainly see the impact of unproductive credit in the Chinese economy, followed by a natural cycle of bankruptcy and rebuilding of balance sheets.
SA and other nations that rely on resources and external capital flows need to be prepared for the eventual manifestation of Chinese cyclicality. Despite worries about rising trade barriers, China is now firmly part of the global economy and its deleveraging will certainly dent local growth prospects.
Savvy investors have made peace with the fact that they cannot effectively forecast the future of the three Cs: companies, countries or currencies. This wise embracing of limitations should not be confused with an understanding of where we are in the cycle of each of the above Cs.
Despite seemingly superhuman achievements to date, the Chinese are very much human. There is a cost to growth fuelled by easily available credit, and rising global rates could set the stage for this cost to manifest.
• Hundersmarck is co-founder of the Old Mutual Titan boutique at Old Mutual Investment Group.