The Algebris Bullet

The Silver Bullet | China: Feeling the Stones of Japanification

Xiamen is a tourist city on China’s southeast coast. It boasts tree-lined beaches, Victorian-style properties and consistent high rankings as the best city to live in the country. It may also soon become one of the most expensive cities to get a place to live. House prices have risen over 15% since last year, according to official statistics in March (NBS). The frenzy has continued into April, with anecdotal reports suggesting that one developer hiked prices three times in two days.

The sales hype is not unique to Xiamen, a tier-2 city according to the government’s 2015 classification. House prices are rising even faster in China’s tier 1 cities, now at +62% YoY in Shenzhen, +25% in Shanghai and +116% in Beijing.

Is China reflating itself into a bigger bubble? The rise in house prices has intensified after last year’s stock market crash. One reason for the rebound is the government’s response following the crash, announced at the 5th Party Plenum last October. Eager to meet its 6.5%-7% growth target and to show prowess in controlling the economy, the Party decided to counter the slowdown with another credit stimulus plan.

The plan lowers mortgage down-payment requirements and stamp duty, introduces a social credit scoring system to evaluate citizens’ creditworthiness and a ranking for banks based on how much they lend. As a result, bank lending activity as well as the stock of total social financing have rebounded to record highs (over 215% of GDP), while local governments have also re-started borrowing (Bloomberg).

But this boom in credit growth and asset prices raises a red flag, for three reasons. First, because it seems that China is trying to counter the slowdown – a consequence of overinvestment in real estate and industrial sectors post the 2008 crisis – with additional overinvestment. Second, because reforms to state-owned enterprises (SOEs) and banks remain very slow. Third, because history tells us that attempts to reflate asset bubbles have not ended well: Japan in the 1980s is a case in point.

Is China at risk of Japanification?

China’s situation today looks similar to Japan back in the ‘80s. Both economies enjoyed years of fast GDP growth, which was supported by strong investment. Both experienced rapid credit expansion, leading to fast asset price appreciation and deteriorating loan quality. In Japan, credit growth was fuelled by loose monetary policy – designed to control the strong appreciation of Yen after the Plaza Accord in 1985. Corporate debt increased by 14% of GDP per year to reach 130% of GDP by 1995, according to Bank of Japan data. In China, a major fiscal stimulus in 2008 coupled with relaxed credit standards and bank reserve requirements led private debt to double since the crisis to almost 200% of GDP. Finally, China is reaching the demographic turning point where the proportion of working-age population starts declining, just like Japan did in 1980s.

In Japan, the financial bust that followed the credit boom lasted two decades. During this time, corporates embarked on slow deleveraging and banks continued to lend, accumulating non-performing loans (NPLs). Between the early 1990s and the system stabilising in the mid-2000s, Japanese banks had cumulatively lost more than ¥100tn on NPLs, equal to 20% of GDP. This led to a stagnation in lending in the 1990s and a contraction in the 2000s. Growth also slowed from around 4.6% per year in the 1980s to around 1% since the 1990s.

If this is what China is heading into soon, the impact on the global economy is likely to be much bigger than Japan back in the ‘80s. China accounts for 17.1% of world GDP, compared to around 9% for Japan in 1990, according to IMF data. China is also the largest commodity consumer – accounting for over half of global consumption for all major industrial metals and over 10% for oil. The most vulnerable countries would be the ones that have become most dependent on China’s growth and hunger for commodities: Australia, Brazil, Russia, South Africa – to name a few.

[clickToTweet tweet=”That said, it is early to make a pessimistic assessment: there are still many fundamental differences suggesting China’s situation today may be better than Japan’s in the ‘80s.” quote=”That said, it is early to make a pessimistic assessment: there are still many fundamental differences suggesting China’s situation today may be better than Japan’s in the ‘80s.” theme=”style4″]

First, China is still at an earlier development stage compared to Japan. There is still room to boost potential growth. For example, the urbanisation rate in China was 54% in 2014 vs already over 75% in Japan in the early 1980s.

Second, there is still some policy dry powder in the form of central bank reserves as well as room for a fiscal expansion – although if compared to potential existing losses in the economy, the net dry powder is smaller.

Third, the balance sheet of Chinese families remains solid. Household debt in China is around 39% of GDP, compared to the peak of 74% in Japan in 2000.

Finally, policymakers aren’t completely in denial. One major factor contributing to Japan’s slow recovery was the delay in decisive policy actions. The Bank of Japan only started quantitative easing since 2001, and the government only started using public funds to recapitalise the banking system after the Asian crisis. If China can learn Japan’s lesson by identifying problems and acting early on, it has better chances of engineering a controlled slowdown and re-tooling its economy.

What could policymakers do to solve the problem? The PBOC is likely to continue easing and reducing reserve requirements, but as we have learnt in Europe and Japan, monetary policy isn’t a silver bullet. Foreign exchange reserves remain high at $3.2tn, and recent data points to stabilisation or even improvements in flows. The government could re-size SOEs and use reserves to clean-up banks from NPLs, like it did in the late 1990s and early 2000s. We estimate NPL ratios to be in the range of high single digits (8-10%), based on an analysis of other countries who experienced credit booms of similar speed and size (given one fifth of investment in China was allocated by local governments and the same portion was financed  by shadow banking, the actual level may be higher).

Authorities have recently been mulling a plan to allow banks to swap bad loans for equity in the borrowing firms. If implemented with the right design and conditions, this plan could speed up debt restructuring and deleveraging for Chinese firms.

Conclusions: Feeling the Stones, but not Falling into the River yet
  1. The probability of an imminent crash is low. China’s challenge is to engineer a smooth restructuring of the economy, diversifying away from the old growth drivers (the real-estate and industrial complex) into services. That said, the current credit stimulus plan appears unsustainable in the medium term, and slowdown risk could return – potentially as soon as later this year.
  2. Decentralisation is a double-edged sword. Even though the central government maintains a strong image of power, policy implementation in China remains up to the local layers of government. Put differently, China is best seen as an aggregation of different provinces rather than one country. On the one hand, decentralisation is one reason why China’s socialist market economy has been more successful than previous Soviet-era communist systems, where prices were determined at the national level. In China, local policymaking can help to adopt more flexible measures, for example macro-prudential regulation to cool down specific housing markets (Shanghai and Shenzhen have recently tightened requirements for new mortgages). On the other hand, however, decentralisation may also mean that reforms could take longer to implement, if the government loses grip on provinces lagging on growth and employment. Social unrest is rising, even though it isn’t always covered by the media.
  3. The real risk is politics. Chinese policymakers have long emphasised the importance of economic transition, but are they really willing to face the short-term pain of restructuring? And can they afford the costs, if slower growth and reforms to inefficient SOEs create social unrest and jeopardise the Party’s position of control? The strong Q1 GDP numbers are reassuring to some, but also point to the danger of repeating a previous policy mistake, i.e. relying too heavily on credit growth and investment to boost headline numbers. If reforms to restructure SOEs and to clean-up banks aren’t implemented quickly, the risk of blowing asset bubbles down the line may become even bigger.

Deng Xiaoping, who led China’s “second generation” of leaders after Mao Zedong, transforming the country in a global industrial powerhouse, coined the saying “Crossing the river by feeling the stones” to describe the reform process and its challenges. This time around, China’s “third generation” of leaders faces an even bigger challenge: the river crossing is filled with sharp stones, but China hasn’t fallen in the water yet.

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