Will the Chinese financial sector be the catalyst of the next global downturn?
“Financial crocodiles” was a phrase used by the all-encompassing Chinese regulatory authorities back in February of this year. They were referring to some of the financial institutions and state-owned companies that have contributed amply to the unprecedented-in-size expansion of debt in the world’s second-largest economy to 270% of GDP. As 2017 has unfolded, it is increasingly clear to us that the major (non-geopolitical) risk facing global asset markets in general is how this debt pile matures from now onwards. The danger that we see is that the path that the leadership and authorities can choose will most likely spoil an otherwise reasonably good cyclical economic picture in China and East Asia in general. For all its size, China remains an economy with a quite centralized pyramid-type decision-making mechanism at its core.
The idea of deliberately expanding total national debt from the already-overstretched 270% of GDP level appears to have been dismissed. Measures of credit such as the increase of Chinese M1 and M2 money supply, the growth of total social financing (followed by many analysts) and even corporate bond issuance are pointing towards a policy decision to not lend. Further evidence is that, according to the Financial Times in a recent article, President Xi Jinping used the same “financial crocodile” phrasing in a Politburo meeting in late April. President Xi referred to some of the giant financial conglomerates, such as Dalian Wanda, Anbang and Fosun. The aim appeared to be to shut off funding to these internationally – known and active giants as part of the slow-down mechanics. This move might have had political motivations but the effect will be the same.
Cyclically, China is not in a bad place, with inflation at low levels (May CPI 1.5% year-on-year) and most growth indicators, including retail sales (+10.7% in May year-on-year) still expanding at a healthy clip. “Animal spirits”, meaning sentiment in the economy and amongst investors, should be reasonably buoyant. But local listed assets, ignoring soaring property prices, have been subdued, with both bond and equity markets under-performing peers around the world this year.
Some commentators and investors (including us) see this as a symptom of the large underlying issue, substantial bad debts in the banking system amounting to perhaps trillions of Chinese Yuan (or even trillions of US dollars). Bad debts in banking systems always have to be dealt with, eventually. This issue has been around for almost as long as the 20 years this analyst has been following China: some form of reckoning may follow but the Chinese authorities proved equal to the restructuring task in 1998, 2005 and 2008-9.
Wrestling the “financial crocodiles” and confronting the debt expansion will most likely impact on global asset prices in the second half of 2017 and into 2018. We may have seen some of the transmission into lower commodity prices already (oil being down -19% year to date). But further falls in commodity prices would be likely. This will also, as it did even with the August 2015 Chinese Yuan depreciation shock, impact sentiment towards credit markets, emerging markets and highly-valued equities such as in the US arena. With global “animal spirits” clearly buoyant presently, markets do not look ready for this type of shock right now.