Once upon a time in the East

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It may not quite be cowboy capitalism, but a showdown is due in China, writes Gary Greenberg

At the end of Sergio Leone’s Classic film Once Upon a Time in the West, the railroad finally arrives in Sweetwater, heralding the end of an era of chivalry, with heroes battling against greed and lawlessness. This moral golden age is replaced by a new era, symbolised by the first steam engine pulling into town, one of civilisation, the rule of law, conventional morality – and smaller men.

Like the images of the old frontier, the Chinese market enjoys a highly romanticised place in the eyes of many Western investors and resembles the old West in many ways. Infrastructure is still lacking, farmers are moving to the cities, businesses are starting up everywhere, and credit is undisciplined. Between 1896 and 1930 in the US, 1,800 car companies flourished, or failed. Today, there are more than 30 car companies in China and few are earning their cost of capital. Competition is fierce and profitability is low.
In the old West, banks issued their own paper, and periodically went bust, leaving depositors in the lurch. In China, interest rates are kept artificially low by the government, so demand for funds far exceeds the amount banks are willing to lend at these rates. A shadow banking system has therefore evolved. Last year, Chinese authorities stimulated growth through easy money. This began to work its magic and China’s stock market took off. Could this recovery herald a return to a sustainable bull market in China?
I don’t believe so. The rally is one to rent, not own. The Chinese economy faces challenges that will hold back its equity markets later this year.

The country’s banks will have to be recapitalised sooner or later. And in the run up to recapitalisation, credit will become scarce. Economic growth will slow, bringing corporate revenue growth down to a crawl. After this rebooting, a cautious lending environment will remain. Without an even more painful adjustment – a major consolidation of Chinese industry – investors won’t pay more than a mid-teens multiple, at best, for Chinese stocks.

It does not help that ‘business as usual’ for Chinese growth is becoming harder. The old drivers of the Chinese economic renaissance were exports, a transfer of home ownership from the state to individuals, urbanisation, a rapidly growing workforce, and massive fixed-asset investment – from housing to airports to high-speed trains. But these drivers are now largely spent. Net exports are now smaller as a proportion of GDP. The massive transfer of homes from the state to the occupants took place years ago. Urbanisation continues but has passed 50%. China’s workforce has peaked and its population is now starting to age. Finally, although China still has a need for improved infrastructure, at 50% of GDP, fixed asset investment is at least 25 percentage points above a sustainable level.

The funding for China’s growth was initially sourced from household savings, foreign direct investment, money created from export receipts and borrowing, mostly at the state-owned enterprise (SOE) and local government levels. China’s GDP in 2009 was $5trn, but in order to maintain economic growth through the crisis the government undertook a massive $585bn stimulus package, which funded a dramatic increase in infrastructure spending.

The stimulus worked, after a fashion. Economic growth rebounded, growing 10.4% in 2010, 9.3% in 2011, and 7.8% in 2012.  But debt levels grew even more. Overall credit to GDP now stands at 193.4%. Financing costs may become a headwind.

Rising levels of credit in an economy are dangerous even in thoroughly capitalist models, but in the ‘command-and-control’ Chinese economy, lending to over-staffed, under-managed SOEs, and to municipal and provincial governments for infrastructure projects is a one-way ticket to a broken financial system, as none of these projects generate enough cash flow to service the debt incurred.

The inability of borrowers to service their debt leads to ‘evergreening’ – restructuring of debt by rolling it over as it matures into new loans. Thus banks show high levels of loans,
little increase in non-performing assets, and little to no credit is left over for the private sector’s dynamic, small and medium-sized enterprises which should be taking over the mantle for the state sector. In an effort to save the patient, the government is killing it. There is no room for creative destruction and no room for efficient enterprises to grow as access to capital is frozen.

In 2012, faced with yet another imminent slowdown, the authorities turned the emergency liquidity pump to high. And January 2013 alone witnessed a RMB2.54trn (more than $400bn) explosion of credit creation. Then in February the Peoples Bank of China withdrew RMB910bn, in addition to undertaking a repo operation. In the past four years, China’s banks have added nearly RMB70trn (over $11trn) in bank assets, almost the size of the entire US commercial banking system.

The real punch line, however, is that all this credit has resulted in growth of less than RMB20.5trn in nominal GDP growth over that period. Last year, credit grew by 30.4% of GDP, but both the economy and investment growth slowed. And many of these loans are to projects which do not generate sufficient cash flow for repayment.

Chinese authorities are nothing if not focused on control, and controlling credit growth is the inevitable focus right now. While the consensus recognises that non-performing loans in the banking system are far higher than the reported 1% of assets, defaults in the shadow banking system could well be significantly larger. Adding the two together, total credit defaults could reach into the double digits.

Chances are that China will retain or even eventually enhance its current position in the global economy, but between now and then a lot must change. China must create and maintain an effective means of allocating credit, freeing up domestic interest rates, growing its corporate bond market and allowing banks to price credit according to risk. It must allow industry to consolidate so that the survivors can earn their cost of capital, repay their loans, and generate returns for savers.

The path to an effectively functioning economy, not to mention political system, was long and volatile in the old West, even after the railroad made it to Sweetwater. There is no reason to think the debt-fuelled boom of the past 10 years indicates a free ride for China over the next several decades.

Gary Greenberg is head of global emerging markets at Hermes Fund Managers


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