China is in the midst of a debt-deflationary bust. It is an ongoing process that has gathered pace recently. Capital outflows are a symptom of this, and a weaker yuan is an integral part of the attempted cure. We expect more of this to come.
We wrote back in the summer of 2014 that a bust is the most likely outcome in China, and we should see this within the next 18-24 months (ie the period around now). We compared China to Japan in the 1990s, where the economy was essentially in a bear market – policy adjustments that led to glimmers of hope, only to be quashed soon after, and the downturn to resume.
While there may not be a defining moment associated with a bust in China, the situation is febrile and policymakers are walking on thin ice.
We highlighted China as liable to a bust in 2014 due to its excessive build up of private debt. Fast rises in private debt that lead to high stocks of debt often lead to financial and economic crises. Ireland and Spain are two recent examples, when in 2010 huge housing busts began that morphed in to crises (click images to enlarge).
Debt growth was allowed to accelerate when China’s response to the financial crisis was a surge in state-directed lending to boost the economy and shield China from the worst effects of the financial crisis. Very rarely, if ever, are such large infusions of lending done prudently. It is impossible to gauge the viability of every project with the correct scrutiny on such a ginormous scale.
China saw the second largest build up of debt recorded over a 5 year period, only beaten by Japan in the run to the bust there in late 1980s. Almost all the other examples in the chart below also did not end well.
We would have expected to see non-performing loans (NPLs) pick up in the years after the surge in lending, reflecting the imprudence of many of the loans made. That this has not happened shows that bad loans are not yet being recognised.
The NPL ratio in China is 1.6%. In previous credit crises in other countries, over the past thirty years, this figure has peaked out at about 15%. Higher NPL ratios in China are highly likely, impairing the banking system, and requiring state injections of capital.
Much like a pony with only one trick, China continues to reach for the credit lever when growth starts to falter. Except it’s having less and less of an effect. New loans are mainly re-financing old projects that are no longer economical, with the result new credit is having a far weaker impact on growth.
For each unit of credit created back in 2008, about 0.8 units of GDP was created. Today that figure is less than 0.5 units.
As growth slows, capital leaks out. What began as a trickle is now a flood. In 2015, we estimate there were about $1 trillion of capital outflows from China.
This has resulted in FX reserves falling 17% from their peak over the last 18 months.
We discussed in a recent report to clients, Understanding Liquidity, the importance of FX reserves in EM countries. They essentially fulfil the role of central bank reserves in developed economies. Broader measures of money are a multiple of reserves. Most important is M1 (current accounts, demand deposits, etc), as this tends to lead economic activity. (If you’re interested in finding out more about our Understanding Liquidity report and our other publications, please click here.)
Unfortunately, when capital leaves China, the process works in reverse. FX reserves fall and this ineluctably leads to a decline in M1. Recently, policymakers have managed to squeeze M1 higher through more credit easing, state-directed lending etc. On this score things have improved over the last few months.
But this easing does nothing to address the root problems in China. China is essentially forcing there to be a higher multiple of M1 to FX reserves to compensate for the decline in FX reserves. If this multiple was to fall to its more normal post-crisis average then, all other things equal, real M1 would be contracting at 15% YoY, not growing at 14% YoY.
Capital outflow has the potential to seriously destabilize China if it does not ease. Unfortunately there are few signs of that at the moment as the sources of outflow broaden to include traditionally sticker forms of capital, such as FDI.
One release valve the Chinese authorities have is the currency. If they allow the yuan to weaken, this reduces the pace at which capital leaves the country. This has been the rationale behind our view of the last year that yuan would weaken.
We have seen this, most visibly against the dollar. But on a real-effective exchange basis, the yuan has appreciated 40% over the past 5 years.
The recent devaluation is minuscule on this scale. China can and will do a lot more to give some relief to highly destabilizing capital outflows, along with other easing measures (interest rate cuts, RRR cuts, backdoor QE, etc) to help ease tightening domestic liquidity conditions and restabilize growth.