Hugh Young is a managing director at Aberdeen Asset Management Asia.
This week marks the anniversary of last year’s stock market crash that some have dubbed China’s Black Monday. Shanghai shares fell 8.5% on August 24, triggering losses on exchanges around the world and causing mayhem in currency and commodity markets.
Apart from the financial losses, the market meltdown damaged the reputation of China’s policymakers. The technocrats who had steered the country through the global financial crisis were humbled as investor capitulation showed the limits of their power to control markets. Investors questioned assumptions about a soft landing for an economy that could no longer sustain its relentless pace of growth. There was talk China would trigger the next financial crisis.
Around the same time, people started monitoring the renminbi for signs of economic vulnerability. Currency weakness, it was argued, clearly meant devaluation – a sure sign that something was amiss. The real reason – that a weaker yuan was a symptom of currency liberalization – was, for many people, less convincing.
One year on, and although the prospects for a sustainable global recovery seem just as remote, things in China have stabilized. Despite another stock market scare at the start of this year, government stimulus is bearing fruit, even if that means slowing reforms crucial to long-term development.
Does this mean China has turned a corner? Only if you ignore a long list of problems that include: ballooning debt; declining corporate profitability; and the countless state-owned businesses such as steelmakers and miners that provide work for entire towns, but struggle to survive.
True, the property market has picked up. Housing inventory levels are starting to clear and construction activity has been recovering: cities such as Nanjing and Hefei have only three to four months of housing stock based on current rates of sale, although these are exceptional. The pace of capital outflows has been decelerating because of capital controls.
When the renminbi weakens, investors haven’t panicked. Better policy communication – central bank officials have started sharing their views on state media – means more people understand why this is happening: with the Chinese currency now guided by a trade-weighted basket of 11 currencies, its relationship with the US dollar will be more volatile.
The problem now is that China’s debt – an intricate web connecting government-linked businesses, state-controlled banks and the bond markets – has snowballed since the global financial crisis. Combined corporate, household, government and bank debt rose from 164% of GDP to 247% between 2008 and last year. However, only a fraction – around $150 billion – is debt denominated in a foreign currency, even after a surge in US dollar bond issuance from China over the past five years.
How much of all this debt can turn bad? Nobody knows: estimates range widely from nearly 7 trillion yuan to some 23 trillion yuan, depending on different assumptions. That’s around $1 trillion at the lower end of these estimates, or some 10% of China’s $10 trillion economy.
Although President Xi Jinping is thought to favor a hard-line approach – shutting commercially unviable state-owned companies, imposing discipline on government-linked borrowers – China’s solution so far has been to unleash more stimulus, albeit on a smaller scale than previous rounds. While this buys time, it also creates even more debt.
So will there be a debt-inspired meltdown soon? The answer is: probably not.
Most of China’s debt is denominated in renminbi, which means, in the worst case scenario, the central government can print money to bail out government-linked borrowers deemed systemically important; Beijing can direct lending at the government banks so this source of financing is less likely to dry up; China is also a net exporter and lender of capital, which means the economy doesn’t rely on fickle foreigners to fund any deficits.
However, stimulus can only be a temporary solution. It can help delay the sudden pull-back of credit financing or abrupt asset value depreciation that, historically, have been catalysts of financial crises. But stimulus cannot replace the reforms needed to fix the massive distortions created by the misallocation of capital into unproductive industries and investments.
To China’s credit, policymakers have made some progress here: they are tackling the problem of moral hazard in the bond market by letting a handful of state-owned companies default on repayments; the financial system is beginning to differentiate between credit risks which, while still rudimentary by global standards, is a breakthrough for local markets.
As global risks grow policymakers have to reconcile the desire for stability with the need for essential reforms. Tough choices lie ahead.
