Professional Documents
Culture Documents
11/07/15
@mattgarrett3)
Intro-
Over
the
last
12
months
weve
witnessed
a
steady
barrage
of
transformative
events
out
of
China,
each
on
their
own
are
hugely
significant
but
together
become
a
hard
to
untangle
ball
of
string.
I
will
highlight
some
of
the
recent
events
and
build
a
context
to
help
shed
light
on
what
is
likely
to
happen
next
in
terms
of
policy,
economic
transition
and
market
impact.
I.
The
Context
China
is
entering
a
new
phase
of
its
economic
lifecycle
after
accumulating
massive
amounts
of
debt
in
its
investment
centric
economic
regime.
The
recent
pace
of
investment
and
subsequent
leveraging
accelerated
greatly
in
reaction
to
the
Global
Financial
Crisis
(GFC)
and
more
recently
has
seemed
to
hit
its
upward
bound
as
more
than
a
full
turn
of
leverage
has
been
added
to
the
economy
in
the
last
few
years.
In
fact
the
rate
of
new
debt
issuance
has
reaccelerated
while
GDP
growth
drifted
to
lower
rates.
These
two
trends
are
the
broad
indicators
or
symptoms
that
are
showing
that
the
Chinese
economy,
in
its
current
form,
is
on
an
unsustainable
and
dangerous
path.
However,
things
start
getting
interesting
when
drilling
down
a
level,
and
a
path
forward
for
policy
emerges.
The
build
up
in
debt
has
been
unprecedented
in
size
and
speed.
From
2007
to
2Q14
the
total
debt
level
and
as
a
percent
of
GDP
increased
by
$20.8T
and
124
percentage
points,
respectively
(chart
1).
This
accounted
for
more
than
36%
of
the
$57T
of
debt
added
globally
over
this
period
(chart
2).
Much
of
this
credit
growth
funded
investment
in
large
infrastructure
and
real
estate
(RE)
projects
as
part
of
the
stimulus
after
the
GFC.
Some
of
which
went
to
projects
that
could
easily
be
considered
malinvestment
(image
1).
The
construction
naturally
led
to
a
surge
in
demand
for
imported
materials,
boosting
sectors
levered
to
materials
exporting
(chart
3).
SOURCE: Bloomberg
Pockets
of
Leverage
Corporates
Chinas
massive
leveraging
by
and
large
has
been
concentrated
in
a
few
sectors
of
the
economy.
China
is
home
to
the
biggest
corp
borrows
with
$15T
of
debt
outstanding
representing
150%
of
GDP
as
of
2014
(chart
4).
The
pace
of
this
corp
leveraging
(change
in
corp
debt
as
%
of
GDP)
leads
the
EM
pack
(chart
5).
SOURCE: HSBC
SOURCE: IMF
Within
the
corporate
sector
the
largest
share
of
debt
has
been
concentrated
within
RE
&
construction,
and
manufacturing.
Drilling
down
another
level,
it
is
a
handful
of
the
largest
firms
that
have
issued
the
bulk
of
the
debt
within
these
industries
(chart
6).
This
is
reflected
in
both
absolute
terms
and
relative
terms
when
looking
at
leverage
ratios
(liability
to
equity
ratio)
among
the
firms
(charts
7-10).
SOURCE: IMF
SOURCE: IMF
Local
Governments
The
other
post
GFC
large
borrowers
were
the
local
governments
(LG),
accumulating
debt
at
27%
per
year
from
2007-2Q14
according
to
a
McKinsey
Global
Institute
report
published
earlier
this
year
(chart
11).
The
latest
statistics,
through
2014
show
total
LG
debt
at
$3.7T
or
38%
of
GDP
according
to
Moodys.
The
run
up
in
this
debt
has
been
the
direct
result
of
policy
response
to
the
GFC
compelling
the
policy
banks
and
regional
banks
to
lend
to
the
LGs
for
infrastructure
and
development
projects.
This
lending
mostly
took
the
form
of
Local
Government
Financing
Vehicles
(LGFV).
In
this
construct
the
LG
pledged
assets
(land,
cash,
SOE
stake,
etc.)
to
the
LGFV,
the
LGFV
would
in
turn
raise
capital
(bank
loans,
trust
products,
bond
market)
to
fund
an
infrastructure/development
project.
This
construct
amounted
to
regulatory
arbitrage,
as
LGs
were
restricted
from
direct
borrowing.
While
the
LG
debt
is
dwarfed
by
corp
debt,
LG
debt
has
some
hair
on
it.
This
is
largely
credit
and
market
structure
issues.
On
the
credit
side
LG
financings
are
limited
to
being
secured
and
repaid
by
property
sales.
This
is
the
result
of
limited
taxing
authority
at
the
local
level
as
well
as
the
central
government
having
claim
on
50%
of
income
taxes.
Finally,
these
are
largely
unregulated
structures
and
lack
standardization.
As
this
paper
nears
maturity
and
needs
to
be
rolled,
risks
exist,
as
funding
sources
are
not
well
established.
This
is
has
caused
policy
makers
to
make
a
big
push
to
get
the
municipal
bond
market
up
and
running
(with
a
few
rescues
of
this
effort
along
the
way).
The
less
levered
Sectors
The
household
sector
has
a
relatively
low
level
of
debt
when
compared
to
the
other
countries
at
about
38%
of
GDP
at
less
than
half
of
that
of
the
US
and
South
Korea.
The
largest
portion
of
this
debt
is
in
the
form
of
mortgages
(another
linkage
of
debt
to
RE).
The
Central
Government
also
carries
a
low
debt
burden
at
about
26%
of
GDP.
In
the
wake
of
leveraging
via
underdeveloped
capital
markets
China
as
a
whole
has
relied
heavily
on
loans
for
sources
of
investment
capital,
which
represent
72%
of
debt
outstanding,
by
official
numbers
(chart
12).
A
lot
of
this
comes
via
opaque
and
fragmented
shadow
banking
channels
(chart
13).
There
are
also
the
serious
issues
of
moral
hazard
and
weak
bankruptcy
procedures.
These
all
amount
to
impediments
for
effective
allocation
of
capital
and
transmission
of
monetary
policy.
Note:
Debt
numbers
do
not
represent
total
debt
but
are
the
sum
of
official
statistics
on
RMB
bonds
(from
the
Asian
Development
Bank)
and
RMB
loans
from
Financial
Institutions
(from
the
National
Bureau
of
Statistics).
Bonds
make
up
only
a
small
portion
of
the
Chinas
debt.
This
represents
a
disadvantage
in
their
aggregate
capital
stack
but
also
an
avenue
for
improvement.
Credit
intensity
and
capacity
are
diverging.
The
amount
of
GDP
growth
generated
for
a
unit
of
credit
created
is
declining
(chart
14).
Looked
at
a
different
way,
if
China
were
to
hit
its
growth
numbers
(6.5%)
and
Credit
growth
were
to
moderate
(10%
-
well
below
trend)
total
debt
to
GDP
would
be
about
350%
by
2020.
II. Recent
Signals
Reveal
a
Path
Forward
China
Inc
is
in
the
midst
of
a
major
restructuring
There
have
been
two
systemic
level
recapitalizations
taken
on
this
year.
First,
the
PBoC
and
MoF
recapitalized
the
policy
banks
in
excess
of
$60B
and
meaningfully
larger
than
initial
estimates.
Second,
is
the
recapitalization
of
LGs
that
Ill
cover
below.
A
new
aggregate
capital
structure
is
being
pivoted
towards
and
is
greatly
changing
their
financings
and
market
structure.
The
pivot
here
is
towards
relying
more
on
equity
capital,
a
shift
towards
more
bond
issuance
and
developing
the
securitization
market.
1) Stabilizing
the
equity
markets
so
corps
can
issue
new
equity
to
reduce
the
stretched
balance
sheets
(charts
7-10).
2) Shifting
towards
more
usage
of
debt
securities
in
the
form
of
bonds
and
securitization.
This
is
most
notably
happening
with
LGs
tapping
the
bond
market
to
refi/swap
out
of
maturing
LGFVs
and
other
LG
debt.
This
required
increasing
levels
of
PBoC
easing
and
finally
the
inclusion
of
the
newly
issued
bonds
as
collateral
for
a
standing
lending
facility.
This
should
be
viewed
as
a
narrowly
avoided
disaster.
3) Expanding
the
balance
sheet
of
different
sectors
of
the
economy.
This
is
likely
to
be
the
consumer,
fitting
with
the
stated
policy
objectives
of
the
CCP
to
expand
consumption.
By
extension
the
industries
that
serve
the
consumer
will
expand
as
well.
The
CG
will
likely
lever
up
as
fiscal
stimulus
or
possibly
any
bailouts
are
needed
going
forward.
4) Increasing
the
carrying
capacity
for
debt
securities
(new
sources
of
funding)
by
broadening
the
investor
base.
This
will
happen
internally
via
innovation
and
regulation.
Commercial
banks
and
fund
houses
hold
more
than
of
these
securities
(Chart
15).
More
significant
is
the
continued
development
of
the
external
market
(part
of
RMB
Internationalization).
China
has
issued
very
little
external
debt,
as
of
2013
less
than
10%
of
GDP
(chart
16).
Coincidentally,
this
happens
to
be
where
most
of
the
action
has
been
of
late.
QFII,
RQFII
(program
for
foreigners
to
in
invest
in
china)
cap
increases
Opening
of
foreign
trading
centers
Issuance
of
Central
Bank
and
Govt
securities
(PBoC
just
issued
$4.7B
of
1yr
CB
bills
in
London)
PBoC
removed
the
quotas
for
foreign
CB,
SWF
and
some
Institutional
investors
holdings
of
bonds
The
launching
of
CIPS
or
Chinas
own
international
payment
messaging
system
for
financial
institutions.
This
is
a
competing
system
to
SWIFT.
Source: DB
Source: IMF
A
Reorganization
of
the
Economy
is
the
corresponding
action
to
the
market
reforms.
The
new
capital
will
have
to
go
to
sectors
of
the
economy
that
will
have
higher
multipliers
and
capacity
to
borrow
(chart
17).
As
has
been
discussed
this
is
the
consumer
and
services
sectors.
Both
of
these
sectors
carry
relatively
low
levels
of
debt
and
dont
have
the
over
capacity
like
the
previous
growth
engines
of
the
economy.
Additionally,
the
household
(HH)
sector
in
China
has
one
of
the
highest
savings
rates
in
the
world
at
about
40%
(Chart
18).
Growth
should
continue
to
be
lead
by
the
Tertiary
or
services
sector
currently
at
about
48%
of
GDP
and
growing
at
8%
at
last
read.
As
a
comparison,
US
and
South
Koreas
services
sectors
represent
78%
and
59%
of
their
respective
GDPs.
Data: OECD
Source: HSBC
III.
2015 has been a year where Chinas central bank has had to repeatedly alternate between
managing crises and averting disasters. Meanwhile, the longer-term plan has further
unfolded which is a transition to the services/consumer economy and a modernization of the
financial system. The end game here, if successful, is a transition where growth from these
emerging sectors is strong enough to overcome the drag from previous excess investment and
capacity. There does exist a real chance that the accumulated debt is too cumbersome to
bare, and a deflationary environment takes hold. This raises the question of what options are
left if this downside case comes to fruition after rates have been taken down to zero and RRR
cuts arent having sufficient impact.
The ultimate act in modernization (being ironic here) would be the final policy response to
a deteriorating situation and that is Quantitative Easing (QE). Ive heard people say the
PBoC is doing QE, but they are more in the alphabet soup of lending facilities phase of
easing. This is closer to where the FED was in 08 with TALF, TSLF, CPFF, etc. In fact
China currently isnt ready to utilize QE if it were needed. Many of the reforms mentioned
above put in place the dynamics for QE to be utilized in a similar way that the FED, BOJ and
ECB have. These dynamics are: 1) fully floating currency; 2) incremental external debt; 3)
issuing larger proportion of standardized gov and corp debt securities. All of which would
take time.
In the absence of significant incremental QE from Chinese or other CBs, these are
potential narratives.
1. Global
rates
rise
as
China
starts
competing
for
funds
in
global
capital
markets.
2. Credit
spreads
are
unlikely
to
go
back
to
their
post
GFC
tights.
I
believe
they
can
widen
out
further.
Both
based
on
credit
cycle
dynamics
and
the
added
net
supply
coming
from
the
east.
3. The
china
consumer
comes
alive
(1.3B
people),
this
is
extremely
important
given
the
worlds
reliance
on
Chinas
growth
contribution.
4. Inflation-
the
conditions
for
a
regime
change
in
inflation
trends
exist.
Part
of
this
scenario
would
include
emerging
inflation
in
pockets
of
the
economy,
through
nontraditional
channels.
But
well
save
this
for
another
day.
Source: Macquarie