China’s deleveraging: will it succeed?

After years of talking about leverage, Beijing has finally begun to back up its words with actions. But S&P Global Ratings believes it is not doing enough to stem credit growth.

China’s deleveraging: will it succeed?

Deleveraging is a tricky business. Just ask Chinese policymakers. They have been talking about the subject for several years, even as the ratio of debt to GDP continued to rise. This year, however, China has started to act.

To be sure, China got an assist from stronger global demand and higher commodity prices. Improving profitability has helped Chinese companies to repair their balances sheets, and supply-side reforms to reduce industrial overcapacity bode well for continued progress. For banks, overall asset growth has moderated.

However, while corporate borrowing has slowed in some sectors, policymakers have eased credit restrictions elsewhere in the economy. Mortgage loans are a major income driver for banks, despite high residential property prices in some locations. Local governments' investment vehicles also remain big borrowers, with public investment spending a pillar of continued high growth.

Overall, S&P Global Ratings believes China is not doing enough to contain credit growth. This led us to lower our long-term sovereign credit rating on China (A+/Stable/A-1) by one notch in September.

A balancing act—household debt is rapidly rising

The trick for policymakers is to figure out a way to reduce the country's dependence on debt, without causing a hard landing or financial crisis. This makes for a tough balancing act. China's leaders are trying to channel funding away from "old economy" sectors--matured industries struggling with overcapacity--into emerging sectors that promise innovation and greater growth potential.

Policymakers are also attempting to reduce the strain on corporate balance sheets through debt-for-equity swaps, merger and acquisitions, or supply-side reforms to cut debt, reduce duplicated capital investments, and support profitability.

As part of our "China Credit Spotlight" series, we have published nearly a dozen articles on the deleveraging process. Tracking China's progress on this front requires an integrated approach. Reforms or actions in one sector have knock-on effects elsewhere. What helps one company or one sector, could be a cost to another.

For example, over the next five years, we expect China's corporate borrowing binge to slow, due to improving profitability and tighter discipline on investment spending. In contrast, we anticipate much faster growth in the household borrowings. China's urbanisation trend still has a long way to go, and this remains a structural driver for housing demand.

However, passing the baton of credit-fueled growth in recent years to households also has many obvious risks. Real estate is already very expensive in parts of China. Prices in major cities have surged in the past 24 months due to very low interest rates and rising household wealth searching for returns. Property prices are coming under control but underlying demand for housing for own use and investment remained high.

If the property market corrects sharply, the ensuing stress would be negative for consumption, banks' assets quality, and local-government fiscal budgets. The property market is a major pillar supporting the Chinese economy, with wide links to various sectors.

The 2008 stimulus created a debt overhang

The long story of how China's debt burden accumulated is well known, but worth repeating. China's captive pool of savings and command over its banking system has been a tremendously successful strategy to fuel its development. By repressing financial costs and directing funds to investments in infrastructure and other public goods, the country was able to accelerate its catch-up development, pulling millions out of poverty and creating an export powerhouse.

Nevertheless, over time, this model led to overinvestment and a reliance on investment spending to support growth, especially after the 2008 global crisis, when the Chinese government took extraordinary steps to provide stimulus.

In most years since that crisis, China's credit growth expanded at a faster pace than nominal GDP. Much of that credit went into infrastructure, which has long payback on investments; or it went into industrial capacity, worsening excess capacity and leading to a deterioration in profitability. As China's overall debt to GDP ratio gets higher, so do the risks, because many borrowers have weak cash flows to service their debt. The bigger the debt pile grows, the harder the economy will fall in the event of a financial crisis.

Reducing default risk is not the only objective of deleveraging. The hope is that increased economic efficiency will follow. Under tighter credit conditions, companies would be required to evaluate investments more carefully. A greater reliance on direct bond or equity financing should intensify scrutiny on managerial investment decisions, improving strategic thinking, risk-management practices, and returns on assets.

Ultimately, the greatest benefit of deleveraging should be that China achieves its objective of reducing its financial risks and rebalancing its economy.

The problem comes is getting there. We consider China's institutional framework as unbalanced and evolving. While the country has had great success in avoiding a hard landing, past policy missteps or financial scares were cured with large doses of liquidity. Thanks to large domestic savings, Chinese policymakers still have much flexibility. But after years of credit growth outpacing nominal GDP growth, the country's financial buffers are thinning.

Unless China curbs its debt appetite, these buffers will continue to thin, diminishing policy response to financial stress.

An unconventional policy approach: "Tight and loose"

China's monetary settings remain accommodative, but S&P Global Ratings believes that behind the scenes, the policy mindset has shifted to "tight/neutral money." For the first time since 2012, banks' asset growth has trailed nominal GDP. Banks have also reined in interbank lending and riskier wealth management products.

Yet at the same time, credit remains easily available to fuel government-related infrastructure investment, and authorities have relaxed access to home-mortgage loans to clear excess housing inventory in less developed cities. Chinese banks are now confronting an unconventional policy setting that could be dubbed as "tight/neutral money and loose credit." Along with other policy initiatives that aim to alleviate corporate debt-servicing burdens at the cost of the banks' financial performance--such as debt-for-equity swaps and administrative caps on banks' fee schedules--this could have far-reaching credit implications for Chinese banks.

We believe the next big test is whether companies can withstand higher financing costs as financial conditions tighten. Smaller and less-capitalised banks may feel the liquidity squeeze and pressures on their capital, leading to distress. Default risks could also increase for the local government financing vehicles (LGFVs) that are relied on to pump up local fiscal and related spending throughout the country.

Meanwhile, financial tools such as securitisation are being developed to transfer risks to the private sector and relieve pressure on companies and banks' balance sheets. So far, the securitisation trend has been positive for asset sales and recapitalization, but China's market for securitised assets remain small, so the impact of this on corporate deleveraging is still limited.

Increasing state intervention at many levels

China's state planners have managed to defy market watchers who expected a hard economic landing, but in the process, authorities are increasingly micromanaging various business and financial decisions. For example, the state is playing a heavy role in mergers between major state-owned enterprises (SOEs) in key sectors that suffer from overcapacity, as well as in equity raising for struggling SOEs under the mixed ownership reform agenda.

Officials are also trying to emphasize alternative models, such as greater use of private-public partnerships (PPP) and project bond issuance. But unofficial local government debt remains high, and the government still sets annual growth targets.

In the insurance industry, Chinese authorities have introduced tax and other incentives to encourage Chinese insurers to invest in long-term infrastructure projects, including PPP and "Belt and Road" initiatives. The government has also encouraged insurance companies to participate in SOEs' equity raising to provide long-term capital for expansions. Such projects and investments could help insurers to better match their long-term liabilities, but they also raise the question of whether insurance assets will be channeled into the deleveraging cause, and if so, will returns be adequate to cover the potential risks.

A broad risk is that the state will interfere too much in the economy as it attempts to deleverage the economy, distorting incentives and creating unintended consequences. For example, the shifting of credit growth to households may overheat property market, contradicting the policy intention of preventing financial risks emerging from a correction in the property market.

Moreover, such meddling will have fiscal costs. For example, China has long relied on state-owned banks to execute stimulus programs, chiefly through increased lending to local governments to invest in infrastructure. Should nonperforming loans sharply rise, the Chinese government would likely opt to support banks, rather than allowing a financial crisis to unfold.

Two types of adjustment: smooth Or painful

The S&P Global Asia-Pacific economics team ran a series of models to estimate both the size of China's credit-to-growth gap, and how long it will take to close.

With the right policies, we believe it is possible to obtain a relatively smooth adjustment over many years. For example, shifting funds and investments to the less-developed interior could spur fresh economic activity. Despite low direct returns on such projects, indirect benefits from increased economic efficiency (for example through better logistics), can be recouped in the form of tax income and healthier SOE balance sheets.

However, China's deleveraging could still come the hard way: through a sharp decline in GDP growth and a surge in credit write-offs. Continued strong credit growth, together with moderating deposit growth, may gradually push up refinancing risks to a level that would be beyond the government's control.

We expect the country's outstanding debt to increase 77% over the next five years. China faces many risks and unknowns as it deleverages, but the biggest risk is that it doesn't act quickly enough to solve the problem before it runs out of its large financial buffers.

(S&P Global Ratings is holding a series of China Credit Spotlight seminars over the next few weeks in Hong Kong, Singapore, Beijing and Shanghai. For details, please visit this webpage)

This article is authored by S&P Global Ratings analyst Christopher Lee  

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