Cross-posted with permission from George Magnus.
Among the many things that perplex and intrigue China watchers and thinkers is China’s credit boom, which has already propelled non-financial, largely corporate and local government, to around 250% of GDP, up 100% over a decade. The widest published measure of credit, total social financing, which probably understates credit availability, is slowing down. But at 15% growth in the year to September 2014, it’s still growing not that much less than two times nominal GDP.
Jon Anderson of EM Advisors Group has a fascinating report out (subscriber only) in which he develops a particular theme about the credit boom that leads to the conclusion that enormous amounts of loans have been made to agents and entities that haven’t spent the proceeds. Jon’s best explanation? A massive money laundering scheme in which funds have been, in effect, stolen. He has allowed me to summarise his argument, and, whatever we may think, it’s worth thinking about (some additional comments of mine in italics).
He concludes that the downswing in credit expansion has to be allowed to continue, and probably will, but the impact of unwinding a ‘virtual’ credit boom on the real economy will be limited, while the impact on banks is significant.
The first thing that Jon finds ‘wrong’ about China’s credit boom is that it hasn’t resulted in any of the economic and financial conditions that other EM have experienced. In fact, looking at China against his universe of EM, he finds no strong evidence of overheated domestic demand, a bottom-left-to-top-right construction boom (except in 2009-10), external deficits, a significant rise in non-deposit bank funding, or bubbles in either equity or home prices. There’s no question about the scale of credit expansion, but it’s not obvious where it’s gone. It’s not gone into the broader economy, or into asset markets, hoarding, capital flight, or US dollars.
The next thing he finds odd is that although the liabilities of households, listed companies, and industrial enterprises have gone up as a share of GDP, these ‘normal’ borrowers only account for about a third to two-fifths of the aggregate rise in debt to GDP. The principal recipients, he argues, have been tens of thousands of newly-created LGFVs (local government finance vehicles) and related construction, developer and infrastructure firms, most of which are only 5-6 years old and don’t fall under any normal corporate reporting or regulatory channels. These entities were created for the express purpose of taking on debt to implement, often single project, infrastructure and construction programmes. (Remember that China’s response to the Great Financial Crisis was a stimulus programme of 16% of GDP, predominantly via credit creation).
Now the plot becomes interesting, because while these recipients unquestionably gorged on credit, it isn’t clear what they did with their credit balances. Reported construction activity has soared in relation to GDP, but Jon asserts that he can’t find any evidence that the same surge in intensity applies to cement and steel usage, or electricity, iron ore, copper and aluminium demand. He also says that typical EM credit booms see credit growth outstrip deposit growth by a fair margin as borrowers raise funds abroad and leverage, but in China deposits have kept pace with credit because these same recipients of much of the credit are also responsible for the growth in deposits.
Pulling ends together, the most likely explanation for a boom in reported construction, way in excess of what was actually being built, along with the the biggest borrowers also being the biggest depositors, is embezzlement on a huge scale. (This certainly resonates with President Xi Jinping’s resolute and robust anti-graft campaign, see below). And if you want a high profile example of how this has manifested itself, you could look simply at the case of former security chief, Zhou Yongkang, who is under investigation for corruption. Earlier this year, Chinese media reported that the authorities had seized close to $15bn in assets from 300 of Zhou’s family members and associates, the bulk of which was in the form of deposits and domestic and foreign securities (http://reut.rs/1k97qcL).
So, leaving the politics aside, the bottom line here for investors is equivocal. Since a lot of the credit in the credit boom never went into the real economy in a material fashion, unwinding the credit expansion (as is now happening slowly) should not lead to a major pinch on the downturn in economic growth. Jon also says that the much commented upon credit intensity of investment-fueled GDP should also be reconsidered because investment includes the frenetic and fake construction activity that’s a fiction. Ergo, capital discipline has been better than suggested by the rising capital-output ratio.
(I’m having trouble with this bit: if fake projects are all accounted for in the investment data, then either China’s GDP is also a fiction since the rise in investment didn’t happen as reported, or we shouldn’t have a seen a rise in the intensity of fake projects in relation to GDP. In any event, residential property investment growth has been falling sharply since 2011, bouncing only briefly in the first half of 2012 in response to a stimulus programme. And it is difficult to overlook home price inflation, rising vacancy rates, and significant housing inventory overhang in Tier 2 to Tier 4 cities. Also debt financed infrastructure that is duplicative or uncommercial in terms of returns and debt servicing is fact).
Bottom line, China can carry on growing at a decent clip even while credit growth slows down a lot. But growth will have to slow down to, say 5-6%, we should expect a big shake-out and bankruptcies among the recipients of the credit gorging extending to trust and other non-bank lenders, and banks and other lenders will be left to deal with the consequences of a significant rise in bad debt and NPLs. (We reckon China can manage financial instability better than in the West before the GFC because all the important financial players are state-owned, but it’s asking a lot for this not to permeate the real economy and jobs, or not to result in renewed financial repression, which is the cornerstone of the economic model which China is trying to change. Not good for the rebalancing agenda).
So there you have it… Jon’s virtual credit boom… in a nutshell.
While there are different ways of interpreting the economic data, there is a strong narrative in Jon’s theme that resonates with President Xi’s anti-corruption campaign, which I’ve looked at here: www.georgemagnus.com/chinas-economy-is-bound-up-with-xis-anti-corruption-campaign/ I also recommend a read of a recent op by Minxin Pei, as he considers the scale of theft associated with the construction and infrastructure boom, notes the networks of corruption that have permeated the Party and state, and wonders not so much whether China is changing, but the uncertainty as to how it’s changing mobile.nytimes.com/2014/10/18/opinion/crony-communism-in-china.html?referrer=
There’s no question that President Xi’s leadership has had to focus on endemic corruption as integral to the task of implementing economic reform, and restoring the Party’s legitimacy. But quite where this all leads, and whether it makes successful and durable economic reforms more or less likely is a moot point. The focus on Party purity, anti-graft, anti-democracy, and ‘traditional culture and values’ is a bit of throw-back, and doesn’t sit comfortably with unbridled optimism.
George Magnus is an independent economist, consultant and commentator. He has a distinguished career that started with some teaching assignments but was spent mostly in the financial services industry. After employment with Lloyds Bank International and Bank of America, he moved to the UK stockbroker Laurie Milbank with the Big Bang in the City of London in 1985, and then to S G Warburg in 1987 as head of fixed income research, and later Chief Economist. In 1995, he moved to UBS as the Chief Economist, based in London. In 2005, he was appointed Senior Economic Adviser, a position he held until going solo in 2012.
