Among the largest questions about China is whether it is going to have financial crisis. Even lately Goldman Sachs, who is typically one of the largest China bulls on many levels, has raised the specter of whether a fiscal disaster could envelope China. We covered some of the weaknesses in the bear case that a financial catastrophe will occur, this time I’m going to concentrate on the bull case and its weaknesses.
I would like to notice some matters which are my individual biases. First, I often believe while bulls underestimate the probability of a disaster that bears overestimate the chance of a crisis. In odds-speak, you’d have something like a lumpy excessive bimodal distribution. While I do not think that the bears have an ironclad case or a catastrophe is unavoidable, I do believe the weight of evidence leads to outcomes that are a lot more pessimistic than bears can make a powerful claim for.
Third, extrapolating the most likely scenarios moving forward, on the previous point, lead much simpler to more fatalistic scenarios even if not a full blown catastrophe. By that I mean, major policy changes that are absent, it is much simpler to see bear and bull cases leading to scenarios that are more negative than favorable results. For example, if China determine to deleverage an in 2017 held fast to a mandate of zero credit increase, that will result leading negative pressures probably resulting in low single digit growth.
This is most likely the most commonly used argument by bulls and in reality underpins pretty much every argument produced by China bulls, including new entrants looking for more beginners resources and ideas for trading options. This is both completely precise and an entirely false sense of security. Let me explain.
Many like to mention China’s high growth rate as proof it remains robust but fail to have a look at the relative rate of growth. From 2009 to 2016 it was 11.4%. That’s very great but will not clarify the problems why we’re discussing whether China is going to have fiscal catastrophe and China faces entering 2017.
What’s concerning is the shift in the Chinese market to one that makes it wholly reliant on credit increase. From 2009 to 2016, these amounts turned in a major manner. From 2009 to 2016, nominal GDP grew at 11.4% but the stock of entire social financing grew at 17.3% or almost 6% faster than nominal GDP. That fundamental ratio has held fairly closely as growth and TSF have moderated slightly in the past couple of years.
The main reason I give this as background, rapid growth by itself will not solve China’s issues. Absent a sustained and significant fall in TSF growth, China will have a fiscal disaster. Mentioning growth as a reason China is not going to have a crisis in isolation is no motive in the slightest.
Not only is the rate of increase in credit to GDP a difficulty, the level is now a serious problem that makes this situation much harder to reverse despite high growth. Organizations and different people arrive at numbers that are somewhat different but the approximations of China’s debt to GDP is about 240-280%. This amount makes it extremely tough to correct this problem even if the growth rates moderate.
Let take a simple scenario to illustrate the point. What makes this unique is that corporate and household sectors and an increasingly significant share funded by shadow banking hold most of this. Why that matters is that this means higher interest carry prices than if it was held by the sovereign. (Let’s ignore for the sake of the activity the particular nature of China sovereign and SOE’s.). WIND states a 4.75% bank index loan rate on 1-3 year debt, so then factor in rates from things like shadow banking, and we can safely us 5% as a round number approximation for the debt service price.
This would imply an annual debt service price equivalent to roughly 12.5% of nominal GDP just to stave off default. By comparison, a like Japan with quite high levels of indebtedness face most held by the sovereign and borrowing costs near zero. In fact many highly indebted nations which China compares itself to face substantially lower finance carry prices. The amount of indebtedness, the rate of interest differential, and also the debt service costs will make addressing this issue increasingly challenging.