Is there a credit bubble in China?
“The fate of China’s banking system and economy has become inextricably linked with its overbuilt and overpriced real estate market. After Japan found itself in a similar position in 1990, it experienced two decades of economic stagnation. China will be lucky to escape such a fate” says GMO’s Edward Chancellor in an August column in the Financial Times. For investors looking at China’s credit markets, are the fears of China bears such as Chancellor valid?
It is a great temptation by economic historians and market commentators to view economics as a science like physics, so that historical experiences can be extrapolated to predict future behaviour. But it is a mistake to do so. There are no certainties in the evolution of financial markets that can be akin to those used by physicists and engineers to be able to design a new car or power plant or indeed, to prevent either from blowing up. The experiences of Japan in the 90s and more recently those of the US and peripheral Europe in 2008/09 have little direct bearing to China’s future prospects. Tim Van Housen, a Partner of Pangaea Finance Partners, points out that while the US and Japan were post-modern/modern economies with mature, developed financial systems, China continues to be at an earlier developmental stage with a sclerotic, immature financial system. China is now undergoing a fundamental transformation of that financial system, in part out of necessity and in support of the longer term general goal to achieve rebalancing of the economy.
As Danny Yee, the CEO of Aktis Capital and a former Chairman of Goldman Sachs Asia argues: “The future of China is as a consuming society. The opportunities for investors lie in those areas where consumption is a big driver of business.”
China is still only 50% urbanised and within the next decade, as many as another 200m people will be moving from the rural areas to become new consumers in the cities. Such a transformation is unprecedented in human history.
Major structural differences Quite apart from the fundamental differences in the stage of development, Van Housen points out there are major structural differences in the financial infrastructure between China on the one hand, and Japan and US and peripheral Europe on the other. These include: the tools of monetary policy that are utilised; Central Bank and regulatory activism vis-à-vis speculation and asset bubbles; the economy-wide breadth of access to credit markets; the relative accommodativeness of effective nominal interest rates for households and the private sector; the capital account; the interdependence and correlation of risks within the financial system; and the nature of leverage in the system: “These matter because as mitigants, aside from the possible degree of systemic risk (e.g., from relative degree of asset valuations, relative degree of leverage, or other precipitants), structural differences get to the very ability of systemic risk to form and be transmitted onward” says Van Housen.
No one should base their ideas of what the US is like based on their experience of Manhattan, nor is the West End of London representative of the UK as a whole. Yet there has been a tendency by commentators to give generalised commentary on China based on what has been happening in Shanghai or at most, the coastal regions and Beijing.
But as Yee argues, 800m of China’s 1.3bn population live in the hinterlands. There is virtually no overlap between the non-bank finance companies (NBFCs) that service SMEs in central and western China with those in the areas that are subject to the credit bubble risk from leveraged real estate speculation. More generally, says Van Housen, the recent breakdown in the correlation of real estate prices, as fully priced Eastern cities decline while the Western and Central China de-couple, is the strongest indication of independence of risk:
Annualized Change in Residential Property Price
City/Province Dec ’10-April ’12 Dec ’07-Dec’10 Dec’04-Dec’07 Beijing -12.5% 23.3% 31.7% Shanghai -4.9% 16.2% 12.6% Zhejiang 7.2% 19.9% 23.1% Chongqing 15.6% 15.9% 15.5% Sichuan 27.8% 17.5% 22.1% Hubei 31.3% 14.3% 22.2%
(Barth, Lea, Li 2012)
Export dependence China’s dependence on exports to fuel growth has also been somewhat exaggerated, probably thinks Van Housen, as a result of concerns over the size of China’s net export imbalance in 2005-2007 which has now passed. Nationally, China’s net exports as a percentage of GDP has recently ranged from about 2% to 4%; using comparable 2010 numbers, China’s was 3.5%, lower than all of Germany at 6.6%, Netherlands at 5.6%, Korea at 4.9%, Singapore at 17.4% and Taiwan at 5.4%.
It is also important to give recognition to China’s central bank for adopting a very pro-active approach to prevent asset bubbles from developing too large, in stark contrast to both the US and Japanese central bank authorities. Indeed, many would blame the 2007/07 crisis directly on the policies of the Fed to mitigate deflation: “Chinese regulators and central bankers pro-actively prick bubbles and attempt to dampen speculative activities not supportive of real productivity helping to build the country. This posture was on display inelegantly in liquidity withdrawals directly in the face of the late June 2013 SHIBOR spike, intended to call out leveraged speculators” says Van Housen.
China’s closed capital account, combined with both a managed currency and a healthy national balance sheet, is also a major structural difference with respect to risk of financial crises. Whatever overvaluation of assets may exist within the PRC is not the result primarily of external hot money investment out of someone else’s savings glut. It therefore does not face the situation that existed in the 1997 Asian crisis as hot money fled the region.
Minimum access Major portions of the Chinese economy have a minimum access to credit. China’s system-wide home mortgage debt to GDP is 15%. The so-called Wenzhou Index for private sector SME borrowers has hovered in the high teens to low 20s percent. So, of the household and SME sectors which do have access to credit, the pricing of its leverage is materially richer than typical policy rates, SOE cost of capital, or rates accompanying high net worth individual services.
Lower balance sheet leverage and lower financial system exposure toward real estate greatly lessens any systemic implications to a decline in property values in China, in contrast to especially the American and also the Japanese experience. Chinese regulatory authorities aggressively reversed polices toward the real estate market generally in late 2010, and this “exit strategy” is often attributed to price declines in markets like Beijing. The total exposure of so-called “shadow banking” is limited in scale. Important recent research comparing China’s and Europe’s shadow banking system post-crisis concludes against any material systemic risk from the shadow banking in China.
Both household balance sheet and financial system debt exposure to real estate is materially less in China today than in the United States and Japan prior to their respective financial crises. Mortgage debt to GDP in China has now grown to 15% in 2012, after its big increase to about RMB7trn ($1.1trn). By contrast, mortgage debt to GDP for Japan in 1990 was 37%, and for the US in 2006 was over 60%. (Nakagawa Yasui, 2009).
More specifically, Van Housen argues that it is reasonable to postulate that particular elements of prior financial crises will not occur anytime soon in China: Central Bank complicity and inaction toward bubbles; open, international hot money inflows to the point of destabilising excess; or formation and collapse of bubbles in credit spreads and equities. As he adds, other than specific currency crises, and related funding crises, there has never yet been a deep and sustained aggregate demand collapse of a rapidly developing country, where nominal GDP growth is high, with commensurately high nominal interest rates and inflation; urbanisation is on-going and has more to continue; productivity upgrade (education, inter-generational skill upgrade, large interior rural human capital resources yet to be exploited) is on-going and has more to continue; and central bank and regulatory posture has a favourable tilt.
In the case of China’s current account structure and fiscal posture, currency/funding crises as we have seen before in emerging markets like Thailand and Mexico are off-the-table: “Structurally, it is questionable whether it is even possible for a systemic financial crisis, with a deep and sustained aggregate demand collapse, to occur in China. Recessions, local idiosyncratic credit blow-ups, on-going episodes of bad debt and mal-investment, and a challenging transition to a balanced economic model may well occur; but systemic collapse, with implications of credit crises and AD collapse, does not appear possible now or in the future” says Van Housen. From an investment perspective, the business opportunity in China non-bank finance consists of: Firstly selecting the right non-bank finance sectors and the best companies within those sectors; Secondly identifying these as the winners from fundamental, broad transformation of a nascent underdeveloped financial system; and thirdly, getting the timing right: now, as the transformation already underway is accelerating while the broader economy is at a turning point (toward higher quality growth and ultimate rebalancing).