China: Pay greater attention to credit supply than the level of debt - Westpac

In view of Elliot Clarke, Research Analyst at Westpac, China’s financial system is crucial for growth, but high complexity creates risk.

Key Quotes

“In the past month, there has been a re-emergence of concern regarding the health of China’s financial system and its high level of debt. As outlined recently by the IMF, the assets of China’s financial system rose from 263% of GDP in 2011 to 467% of GDP at the end of 2016. This extremely rapid expansion has come about as wealth has grown, but also as activity has become more credit intensive – that is, a greater proportion of activity being funded by debt. The ratio of total credit to GDP is currently 25 per cent above its long-run average. This ‘credit gap’ is described by the IMF as being “very high by international standards and consistent with a high probability of financial distress”. Is this the precursor of a debt crisis? We don’t expect a crisis, but an unintended tightening of credit supply is a key risk.”

“When assessing China’s debt stock, it is important to recognise two points: (1) China’s liabilities are also its assets because it does not borrow from the rest of the world; and (2) the debt is highly concentrated amongst State-Owned Enterprises (SOEs) who are under the control of the government. These factors make it much easier for any defaults to be worked through. Further, for every uncompetitive, highly-leveraged SOE, there is an efficient, productive entity interested in taking their market share – the steel sector being a prime example. This is not to say that creditors will never suffer losses, or that sentiment will not be hit on occasion, but rather that the process can and will usually be conducted at a manageable pace, with clear resolution.”

“Versus corporate debt, China’s current stock of household debt remains low. However, it is growing rapidly and so needs careful management. This is why authorities have sought to rein in the housing market over the past year, and also why their development agenda is focused on growing income and wealth, and distributing it equitably. This combination of factors will keep household debt in check, both in the short and medium-term.”   

“The biggest threat to China’s long-term economic and financial health is actually not the scale of the debt itself, but rather the complexity and opacity of the system that supplies it. To date, banks and shadow banks have dominated the supply of funding. And, within the banking sector, it has increasingly been the smaller banks that have driven growth. Between 2010 and 2016, as the assets of the big 5 banks remained unchanged (relative to the economy) at 114% of GDP, other bank assets swelled from 99% of GDP to 148%.”

“The shadow banking system also grew rapidly over this period, wealth management products (WMPs; the prime source of funding for the sector) growing five fold. Credit growth was also aided by a complex system of funding and securitisation deals between the smaller banks and the non-bank sector, which kept bank’s non-performing loans low, and by strong growth in short-term funding via the interbank market.”

“The consequence of these developments is that many smaller banks have come to rely on non-deposit funding (interbank and WMPs) and are also potentially not adequately capitalised. The authorities are seeking to improve bank oversight; awareness of credit risk; and stable funding, but this will take time. In the interim, the susceptibility of the banking system to illiquidity and/or a credit event will remain a key risk. Once you are a ‘credit intense’ economy, any impediment to credit supply will shock growth. For China, this is particularly true of regional areas who depend on the smaller banks. Our core view on China is positive, but risks to growth and financial stability always need to be kept in mind.”