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Is China making another bet on its economic model?
Peter Garnry
Chief Investment Strategist
Résumé: The prevailing narrative on China is that its economic model is broken and the government is not doing enough to stimulate the economy, but balance sheet growth among Chinese banks shows that overall credit growth is the highest since Q1 2012 suggesting that China is actually doubling down on its economic model. The challenges for China is that its economic model works under the condition of low debt levels and plenty of available productive assets, but since 2011, the market realized that too much investment was going into non-productive assets and the equity market outlook slowly deteriorated. China faces several challenges and tough policy choices in the years ahead to advance from its current economic model.
Key points in this equity note:
- The prevailing narrative on China is that the economic model is broken and that the government is doing too little to stimulate growth. Looking at balance sheet growth among Chinese banks suggest that overall credit is expanding at the fastest rate since Q1 2012.
- China’s economic model of extensive investment as a share of GDP broke around 2011 judging by how the market valued Chinese banking assets and the drop in balance sheet growth among Chinese banks.
- China faces some difficult policy choice over the coming years to advance from its previous economic model. The country has several options but they all come with various challenges and time frames.
- The verdict on China’s outlook in the equity market is quite negative with Chinese equities continuing to underperform its emerging market peers and extending its relative underperformance against US equities that started in 2007.
Credit expansion is potentially the biggest since 2011
China started the year as a positive story with expectations of higher growth after ending its restrictive Covid-19 policies, but this year the narrative has increasingly turned darker. Today, Chinese regulators announced a surprise cut in key prime rates except the 5-year loan prime rate as the government attempts to loosen credit conditions while preserving banks’ profitability to maintain financial stability.
The common narrative on China is that its economic model is broken and that the government is taking a light approach to dealing with the slowdown in the economy. The economic model that propelled China to superpower status run into troubles 12 years ago and the recent economic slowdown this year can partly be explained by inflation in the developed world which is causing a decline in volume of goods which in turn leads to less factory utilisation in China.
The investment driven economic model of China requires constant investments and lending. Many have pointing out that lending growth has slowed as seen by the credit impulse (12 change in net new debt in percent of GDP), but this measure only looks at volume of financing to the domestic non-financial corporate sector and households. As the Chinese banking system is an extended branch of the government we prefer to look at the aggregate balance sheet of Chinese banks. The Chinese banking system is concentrated among four banks and thus the aggregate balance sheet of these four banks provide an adequate picture of overall credit growth.
As the chart below shows, China’s bank balance sheet growth was 14.5% y/y in Q1 2023, the highest growth since Q1 2012 highlighting a rapid expansion going against the prevailing narrative on China. So where is the disconnection between this picture and the common narrative? Social financing is related to the private sector, which faces hard budget constraints and thus under the current economic conditions are holding back on lending due to lack of productive assets. To keep GDP growth afloat the Chinese government is extending credit and investments through sectors with soft budget constraints (local governments and state-owned enterprises). Make no mistake, China is doubling down on its existing economic model as it has no other choice in the short-term.
Overinvestment in non-productive assets, demographics headwinds, and policy choices
In a thread yesterday, Michael Pettis (Senior Fellow at the Carnegie Endowment and scholar of China) outlined his views on China in a comment to the Wall Street Journal article China’s 40-Year Boom Is Over. What Comes Next?. He starts by saying that China’s economic model did not break recently as a function of the pandemic, that was probably just an amplifier, but instead it broke 10-15 years ago. The economic model is the one applied by Japan and the Soviet Union post WWII enabling high GDP growth through excessive investment as a share of GDP. In China, investment share of GDP is 44% which has no comparable historical precedent. It works well under certain conditions, with one being that many productive assets are available to be expanded. This was the case in China from 1980-2011.
Pettis provides an estimated range of 10-15 years for when China’s economic model broke indicating around the years 2008-2013. If one uses the MSCI China relative to MSCI USA in total return USD terms, then China’s economic model peaked in 2007 and thus also its economic model through the lens of financial markets. Using bank balance sheet growth rates as the yardstick the economic model broke around Q2 2011. One could argue that it was 2008, as Pettis indicates when you look at different indicators highlighted in this equity note, but if you look at the rebound in Chinese banks’ market value to total assets in 2010 and early 2011 it shows that around this time there is still confidence in credit provision by Chinese banks and that there is a positive multiplier effect into the economy, at least perceived by investors.
After 2011, the market value of Chinese banks begin to grow much slower than their balance sheet in a systematic way suggesting that the largest Chinese banks are increasingly being incentivized to lend out to local governments and state-owned enterprises despite lower credit quality. Because China was running out of productive assets to reinvest into, the hard budget constraint in the private sector meant that the private credit impulse got less and less potent, because the private sector cannot afford to invest into non-productive assets indefinitely without the risk of bankruptcy. As a result, banks’ balance sheet growth declined rapidly from 2011 to the bottom around mid-2018.
In the years before the pandemic, balance sheet growth accelerates while banks’ market value goes nowhere indicating forced lending with investors acknowledging the limited market value of these additional loans. Under a normal credit cycle this is not the behaviour you would expect as market value of banks would increase with higher loan growth. The overall market value to total assets among the four largest Chinese banks has fallen to just 3.5% in Q1 2023 down from 12.5% in Q1 2011 and the peak of 34% in Q4 2006. This measure highlights pretty well how undercapitalized the Chinese banking system really is and why restructuring is coming to the overall financial system, unless Chinese policy makers choose the Japanese policy of the 1990s. This entailed propping up banks with government capital amortizing the overinvestments over a couple of decades. This is market economic wise a bad policy choice, but politically it might be the most sensible solution.
Beyond the short-term considerations of economic growth, debt, economic models etc. China is alsp facing longer term constraints from its demographic path. These headwinds will in itself cause challenging dynamics, but with negative net immigration making it impossible to offset the domestic demographics tough policy choices will have to be made.
Michael Pettis described back in April 2022 how China has five policy options.
- China can stay on its current path and keep letting large amounts of nonproductive investment continue driving the country’s debt burden up indefinitely
- China can reduce the large amount of nonproductive investment on which it relies to drive growth and replace it with productive investment in forms like new technology
- China can reduce the large amount of nonproductive investment on which it relies to drive growth and replace it with rising consumption
- China can reduce the large amount of nonproductive investment on which it relies to drive growth and replace it with a growing trade surplus
- China can reduce the large amount of nonproductive investment on which it relies to drive growth and replace it with nothing, in which case growth would necessarily slow sharply
These are the same five paths, by the way, faced by every other country that has followed the high savings, high investment model. Each of these paths creates its own systemic difficulties and each, except for the first, implies substantial changes in economic institutions that, inevitably, must be associated with substantial changes in political institutions. This may be why in the end every previous country followed the last of the five paths.
If our intuition of what is going on in China is right, based on changes in banks’ balance sheets, then China has clearly chosen the first path in the short-term attempting to keep GDP afloat under the old economic model. The second path is also being pursued as China is moving to become technological independent from the US and Europe, although the various trade restrictions from the US are making this path more challenging and potentially longer than imagined before the Trump presidency. The third path is incompatible with the virtues that the Chinese government wants to see. Too much consumerism would be viewed as to Western and decadent in terms of culture. The fourth path is an option, but the fragmentation game and inflation in the Western world have made this path more challenging, but the new BRICS symposium is definitely going be set up along the lines of the fourth path described above. However, if China wants to become the center of the future BRICS economic system then it is more likely that it is the other countries that become trade surplus countries to China and not the other way around. The fifth path is incompatible with China’s core values around government stability. To sum it up, China’s policy choices over the coming years are difficult and investors should pay close attention as what happens in the second largest economy impacts everything around the world.
Chinese equities reflect the negative outlook
Hang Seng futures were down more than 1% again today down 13% for the month extending to new lows this year as the key benchmark index is down 11% year-to-date. Chinese equities are still higher relatively than equity markets from the so-called “fragmentation winners”, but the relative gain is shrinking fast. In USD terms, the Chinese equity market has been in a perpetual decline against US equities since their relative peak in late 2007. With too much investments in non-productive assets and China’s demographic headwinds ahead the policy choices over the coming years are crucial and will determine China’s economic trajectory over the coming decade.