Markets are underestimating the potential for turmoil in the world’s second largest economy
It has been a tough few months for China’s economy. Years of credit-intensive growth have left the government with a huge debt pile – much of it off the books from shadow banking. The deleveraging process is currently in full swing as the government cracks down on the sector. This is proving painful as recent data has shown.
Chinese equities have been down while the onshore renminbi exchange rate fell to its lowest for 12 months in July.
Much of the media is attributing these moves to US president Donald Trump’s trade crusade against China. Some even suggest it may be a deliberate tactic on Beijing’s part to show Trump what a trade war would actually look like. But this misses the point: internal weakness is already enough to justify dampened investor sentiment there.
Back in 2015, there were similar concerns over China’s slowing growth rate, under pressure currency and credit-worthiness of many companies. Then, the government’s response was to inject large amounts of liquidity into the system and pump up the economy. It worked, and demand from China’s growth spurt was one of the main reasons 2016 was so positive for the global economy and emerging markets, in particular.
Reluctant to act
Now, however, the government appears reluctant to do the same. While it has effectively eased financial conditions somewhat recently (and is the only emerging market to do so), it shows no sign of embarking on the same stimulus programme as a few years ago.
That is understandable; the credit-fuelled binge of 2015/16 is one of the reasons the problem now is so big. Overleveraging – particularly among the old and monolithic state-owned enterprises – led to a huge build-up of debt in weak institutions.
Just as historically low rates and quantitative easing perpetuated zombie companies in the west, many Chinese companies have come to rely on easy credit for their cashflow.
The fact much of this borrowing came from the shadow banking sector and was kept off the books is also important. From the government’s perspective, a large part of the problem is it does not even know how badly companies are indebted – even the SOEs directly run by the state. Misreporting is widespread.
This is symptomatic of a wider problem in corporate China: governance structures are weak. This may sound an odd thing to say of a country whose ruling party is about as iron-fist as they come but recent news backs it up.
Last week, China’s statistics bureau acknowledged it had revised past data on corporate profits. It also revealed an investigation had uncovered 72 cases of illegal statistical manipulation at the national level and more than 7,000 cases at the municipal level between 2017 and April this year.
This makes a huge difference to economic data and casts more doubt on the reliability of official figures.
For example, the bureau reported industrial profits had grown by 16.5 per cent on the year during January to May once last year’s figure was revised down. But without that revision, the figure for this year would be a 6 per cent drop from the year before.
Even the retail sector – thought to be highly accurate in its reporting – showed a huge downward revision: the bureau reported 7.5 per cent year-on-year sales growth in January to May, but based on last year’s figures it would have been a 9.1 per cent decrease.
The careers of Chinese officials are often tied to GDP and tax data, so they have incentive to pressure companies into padding reports.
This is important, as it erodes one thing that reassures investors on China: that the state is in full control.
No matter what measures the government rolls out to counter this economic weakness, if they are going on false information, they likely will not be effective.
So, the extent to which the party-state apparatus is in control of the running of corporates and the SOEs is exaggerated.
Prepare for turmoil
This is why we think markets may be underestimating the potential for economic turmoil in China. The combination of excessive debt leverage and widespread financial misinformation is reminiscent of the situation in the US prior to the financial crisis.
When you add in a general economic weakness and the external shock that could come from Trump’s trade wars, things could quickly turn for the worse in the world’s second largest economy.
China’s ruling party is about as iron-fist as they come, but its governance structures are weak
To be clear, we do not think a crash is the likeliest outcome. While the sense of control may be exaggerated, the centralised nature of power in China means the government can react quickly to dangers in the economy. What is more, the state has a healthy balance sheet and can can take a huge chunk of the debt burden off SOEs and the private sector if necessary.
But we do think markets underestimate the potential for a crash. The government will try to restructure and deleverage the economy, but things could spiral out of control and cause a sudden downturn – not just in China but in all emerging markets and to some extent the global economy.
Lothar Mentel is chief executive of Tatton Investment Management