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China: kicking the can down the road

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As the Chinese authorities inject a fresh $1trn in new credit in the first quarter of 2016, Economist Marcus Wright examines this latest development and what it means for China and the world economy.

Published in: Economy & Finance

China: kicking the can down the road

  1. 1. China: kicking the can down the road Marcus Wright, RBS Economics, April 2016 1
  2. 2. Information classification: Public/Internal/Confidential/Secret 2 What’s this all about? • China has reverted to what it knows best – engineering a credit boom to support investment. • It will likely delay China’s hard-landing. • But only temporarily. China has been getting less growth bang for its credit buck since the crisis. • It doesn’t change our fundamental view of China’s economy – it remains beset by major problems including over-capacity in key sectors and hidden non- performing loans in the banking sector. The proverbial can is being kicked down the road. • It’s a short-term positive for the global economy. It might make 2016 “okay, but not great” rather than deteriorate further. But it won’t be enough to throw lower for longer off track. • China’s medium-term financial stability risks have increased. And the UK is financially exposed.
  3. 3. Information classification: Public/Internal/Confidential/Secret 3 • China has engineered yet another credit boom to arrest the sharp drop in growth. • New financing into the economy in Q1 was the strongest on record. • If all that financing was an economy on its own it would be the world’s 16th biggest, not far off the size of Mexico. • While we previously stated that policy making was not calibrated to the economy’s needs it has now shifted even further away from what is desired. • The proverbial can is being kicked down the road. 0 200 400 600 800 1,000 1,200 1,400 1,600 China Q1 New Financing v Economy Ranking ($ Bn) China - Q1 2016 New Financing Source: Bloomberg , IMF 1. China has reverted to what it knows best - 1,000 2,000 3,000 4,000 5,000 6,000 7,000 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 China - New Financing (Yuan Bn) Source: Bloomberg
  4. 4. Information classification: Public/Internal/Confidential/Secret 4 • China is locked into a credit- intensive form of growth. • The credit binge is being supported by fiscal expansion - the planned fiscal deficit for 2016 will be the biggest in at least 34 years. • China on the face of it has plenty of room for fiscal expansion. Public debt is merely 30% of GDP. • But that excludes local government debt. It could be as well over twice the 30% figure. • And the government will likely have to pay for a significant banking sector bailout in the coming years. 2. It’s the third distinctive credit wave since the crisis, and it’s supported by fiscal expansion -3 -2 -1 0 1 2 China - Fiscal Balance (% of GDP) Source: IMF, China NPC 2016 Target announced at NPC 0 500 1,000 1,500 2,000 2,500 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 China - Monthly New Financing (Yuan Bn) Source: Bloomberg 1. Post-Crisis Response 2. The post-crisis response credit pick-me-up 3. 2016 Boom
  5. 5. Information classification: Public/Internal/Confidential/Secret 5 • The renewed credit deluge seems to have arrested the decline in growth. • After slowing significantly in 2015, much more than the headline figures suggest, China’s growth may have bottomed, temporarily at least. • Real estate and infrastructure investment growth rates have risen into Q1. • Even steel seems to be on the up. • The usual build-up of steel inventories over the winter was much less than usual. And it’s already being drawn down. 3. It seems to have got traction 0 5 10 15 20 25 30 China - Fixed Asset Investment (% Y/Y Change) Real Estate Infrastructure Manufacturing Source: Bloomberg 0 1,000 2,000 3,000 4,000 5,000 6,000 China - Steel Futures (CNY) Source: Bloomberg 0 100 200 300 400 500 2012 2013 2014 2015 2016 China - Winter Steel Inventory Build (Rebar) Source: Bloomberg
  6. 6. Information classification: Public/Internal/Confidential/Secret 6 • The authorities have engineered yet another house price boom. • Easier credit and a reduction in the required deposits for first-home buyers (from 25 to 20%) and second home buyers (from 40 to 30%) have helped. • House prices in the largest cities (Shanghai, Beijing, Shenzhen, Guangzhou) rose a staggering 30%y/y in March. • But the market remains afflicted by oversupply. • China’s house prices are prone to wild swings. The next downturn is unlikely to be too far away. 4. House prices are on the rise but….. -10 0 10 20 30 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 China House Prices (Newly Built, % Y/Y Change) Tier 1 Cities Tier 2 Cities Tier 3 Cities Source: Bloomberg 0 10,000 20,000 30,000 40,000 50,000 -10 -5 0 5 10 15 20 China - House Prices v Floor Space for Sale House Prices (All Cities - % Y/Y Change) - LHS Residential Floor Space for Sale (10,000sqm) - RHS Source: Bloomberg
  7. 7. Information classification: Public/Internal/Confidential/Secret 7 • China’s post-crisis credit waves have been getting less growth bang for their buck. • More and more capital is needed to produce an extra unit of output. • The return on capital has been declining steadily since the crisis, as it has across emerging markets as a whole. • So there are doubts about how long this latest growth fillip will last. • It could fizzle out before the end of the year. 5. Less growth bang for its credit buck 2 2.5 3 3.5 4 4.5 5 5.5 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 China - Incremental Capital Output Ratio Source: OECD 4 6 8 10 12 14 2001 2003 2005 2007 2009 2011 2013 2015 MSCI China - Return on Capital (%) Source: Bloomberg
  8. 8. Information classification: Public/Internal/Confidential/Secret 8 The economy remains beset by: • an excessive reliance on investment to drive growth • a structurally low share of GDP going to household incomes • over-capacity in key sectors • hidden non-performing loans in the banking sector • ad-hoc, reactive policy-making that fails to address the underlying distortions in the economy – the transition to a less debt-addicted, less investment-driven growth model remains some way off 6. It doesn’t change our view on China
  9. 9. Information classification: Public/Internal/Confidential/Secret 9 • China’s rapid debt build-up has been matched by sharp rise in the cost of servicing that debt. • It is widely agreed that China’s banks are sitting on non-performing loans well in excess of official figures. But estimating the true size of the problem is very difficult. • Our own estimate is the NPL ratio is around 25%. In the most pessimistic scenario NPLs are closer to 35%. • We maintain the view that China won’t experience an out and out crisis. 7. A more painful day of reckoning awaits 15 18 21 24 27 30 33 100 120 140 160 180 200 220 240 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 China - Debt to GDP and Debt Servicing (%) Household and Corporate Debt as % of GDP - LHS Debt Servicing as Share of GDP (%) - RHS Source: BIS, Bloomberg 0% 5% 10% 15% 20% 25% 30% 35% 40% Reported Optimistic Central Pessimistic China - Estimating Banking Sector NPL Ratio (%) Source: IMF, Penn World Tables, Bloomberg, Macrobond, RBS Economics
  10. 10. Information classification: Public/Internal/Confidential/Secret - 200 400 600 800 1,000 1,200 1,400 1,600 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Financial Exposure to Ch & HK ($ Bn) World UK Source: Macrobond 10 But the consequences of its credit boom will be far from painless. In the coming years we think China will experience: • a balance-sheet recession (the debt hangover) as debt-burdened corporates prioritise debt minimisation; • an impaired (eventually) banking system, constraining the reallocation of credit and productivity growth; • a hangover of misallocated labour from the financial boom, also constraining productivity growth; • an inadequate reform effort. Our ‘not a blow-up, but many difficult years’ view on China remains. 8. China’s challenging future The risk from financial exposures • It’s too early to tell whether global financial exposures to China have increased in recent months in tandem with the credit boom. • But even if it hasn’t, the latest credit deluge increases medium-term financial stability risks in China. • The UK’s exposure to China is a concern.
  11. 11. Information classification: Public/Internal/Confidential/Secret 11 @RBS_Economics RBS Economics Please keep in touch
  12. 12. Information classification: Public/Internal/Confidential/Secret 12 This material is published by The Royal Bank of Scotland plc (“RBS”), for information purposes only and should not be regarded as providing any specific advice. Recipients should make their own independent evaluation of this information and no action should be taken, solely relying on it. This material should not be reproduced or disclosed without our consent. It is not intended for distribution in any jurisdiction in which this would be prohibited. Whilst this information is believed to be reliable, it has not been independently verified by RBS and RBS makes no representation or warranty (express or implied) of any kind, as regards the accuracy or completeness of this information, nor does it accept any responsibility or liability for any loss or damage arising in any way from any use made of or reliance placed on, this information. Unless otherwise stated, any views, forecasts, or estimates are solely those of RBS’s RBS Economics Department, as of this date and are subject to change without notice. The classification of this document is PUBLIC. The Royal Bank of Scotland plc. Registered in Scotland No. 90312. Registered Office: 36 St Andrew Square, Edinburgh EH2 2YB. The Royal Bank of Scotland plc is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. © Copyright 2015 The Royal Bank of Scotland Group plc. All rights reserved Disclaimer

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