What will the year of the dog bring?

As China celebrates the coming of the Year of the Dog, our head of asset allocation research Edward Smith explains why the pace of growth in China matters for investors everywhere. Happily, we don’t expect any nasty bites.

Over the past few years, many of the largest stock market falls have been caused by concerns that China’s fast-paced economic growth could suffer a sharp slowdown – even if it was all bark and no bite. Given widespread assumptions that China will overtake the US to be top dog of the global economy, the prospects for the new year in China matter for any clients whose investments you look after. Fortunately, we don’t see a slowdown as a significant threat.

To get some clues on the direction of the economy, we were closely watching the Communist Party’s National Congress in October last year. It approved the line-up that will govern the country for the next five years, with President Xi Jinping firmly at the helm. But clarity on how the government would balance the trade-off between reducing debt and upholding growth was lacking.

President Xi repeated his commitment to reforms already announced in 2015, including reducing excessive lending to state-owned enterprises, improving efficiency and ensuring financial stability. Yet progress has been lacklustre and only a few struggling firms have been allowed to fail.

We believe China’s growth rate is more likely to slow than reaccelerate over the coming year, but a significant policy-induced slowdown seems unlikely in the wake of the 19th Congress.

A tighter leash

One notable shift over the past 18 months is government’s acknowledgement that high levels of debt pose a risk for future growth. It realises that the days of high-speed growth are over and short-term policies must be abandoned to avoid a financial crisis.

Will China’s debt come back to bite it? It’s certainly big. According to the Bank for International Settlements, total debt excluding the financial sector is 258% of GDP (although the figure is 268% across advanced economies). The nonfinancial corporate sector is particularly indebted at 165% of GDP, while the household sector is relatively light on debt.

Yet the size of an economy’s debt mountain has little bearing on the likelihood that it will trigger a debt crisis. It’s the speed of accumulation that matters. And we can get a sense of this from looking at how far the debt-to-GDP ratio has moved above the long-run trend.

In 2010, China breached the threshold that has triggered 70% of the world’s debt crises over the past 50 years. Since then the debt-to-GDP gap has fallen as debt accumulation has slowed. Growth in non-bank loans (the shadow banking sector) has fallen precipitously due to government policies.

If President Xi is serious about reform and financial stability, then he is in a strong position to follow through on it. He consolidated his grip on power by removing rivals during an anti-corruption campaign. Now only two members of the newly announced seven-member Politburo Standing Committee are outside his inner circle.

Beware of the dog

Why has there not been a debt crisis already? Firstly, most of China’s debt is funded with domestic capital. Questions over debt sustainability do not translate into a balance of payments crisis, like the one in Asia in the late 1990s. China is still a net creditor to the rest of the world, with a gross national saving rate of about 45%.

Second, loans from domestic banks are largely funded with deposits. Indeed, in 2017 the regulator banned banks from obtaining more than a third of their funding from interbank lending (which was one of the main causes of the global financial crisis).

Third, most of China’s debt has been issued by state-owned banks to state-owned firms and local government entities. Defaults can be averted by shifting money around different branches of the state.

But that’s not to say there’s nothing to worry about, and that the metaphorical ‘beware of the dog’ sign can be taken down. Excess debt has the potential to dramatically reduce growth and lending to productive projects. Investors should take note because China has accounted for 30% of global growth since 2010.

We estimate that more than 40% of all credit outstanding in China has failed to generate a sufficient economic return to render it viable. Unsurprisingly China’s productivity growth has plunged. That is why reform is so important for the country’s ability to deliver long-term returns.

Apparently dog years have different characteristics, depending on the type of dog. This year it’s the Earth Dog, which is said to be serious and responsible, with a high chance of success.

Here’s to the Earth Dog!

You can read more about our views on China and the rest of Asia in our latest InvestmentInsights.


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