Download economic insight GREATER CHINA Quarterly briefing Q3 2013

economic Insight
Greater China
Quarterly briefing Q3 2013
Cash crunch illustrates need for
Chinese banking reform
Welcome to ICAEW’s Economic Insight: Greater China, a
quarterly forecast for the region prepared specifically
for the finance profession. Produced by Cebr, ICAEW’s
partner and acknowledged experts in global economic
forecasting, it provides a unique perspective on the
prospects for China over the coming years. In addition
to mainland China, we also focus on the Hong Kong
and Macau Special Administrative Regions.
After several months of less positive economic data,
a liquidity shock in late June was the last thing China
needed. Although markets have now settled again, the
episode has brought the difficulties of the country’s
financial sector into clear focus. The supply of credit
in China shot up in the wake of the global financial
crisis as investment became the engine of growth, but
it is increasingly clear that not all the ventures funded
were wisely chosen. Meanwhile, tight regulation of
the banking sector has sent investors seeking higher
returns elsewhere, into the booming shadow banking
sector. Is China’s credit bubble about to burst? This
issue of Economic Insight: Greater China explores the
outlook for the financial sector in the People’s Republic,
exploring whether Chinese growth is at risk from
shady debt management practices and how market
liberalisation is needed to match funds with growth
opportunities.
Shibor shock
On 20 June China’s interbank credit markets juddered
to a halt, as the Shanghai Interbank Offered Rate
(Shibor) 7-day interbank interest rate reached a record
at 12%, while the rate banks paid to borrow from each
BUSINESS WITH CONFIDENCE
icaew.com/economicinsight
other overnight soared to more than 13%. This sharp
diversion from trend rates, illustrated in Chart 1, set
banks scrambling to ensure they had sufficient liquidity
to meet their obligations.
Chart 1: Chinese interbank lending rates, SHIBOR,
one week and overnight
%
16
14
China’s credit accelerator
In the aftermath of the 2008 global financial crisis,
China’s government primed the pump with an
enormous fiscal intervention, pouring capital into vast
infrastructure projects. As Chart 2 shows, the total
amount of funding available to the economy from banks
and other institutions (denoted total social financing1)
peaked at 68% of GDP in 2009, but has remained above
pre-crisis levels since. In fact, total social financing
has grown consistently since the crisis, and the rate of
increase accelerated further last year.
12
10
Chart 2: The growth of China’s shadow banking
sector – Bank loans and total social financing,
four quarter moving average and social finance as
percentage of nominal GDP
8
6
4
2
0
August
2010
Feb
2011
August
2011
Feb
2012
1 Week
August
2012
Feb
2013
August
2013
overnight
Source: Macrobond
%
80
5,000
70
4,000
60
50
3,000
40
2,000
The cash crunch had a number of immediate causes –
customers made extra withdrawals before the Dragon
Boat holiday, while businesses were also removing their
funds to pay tax bills. Additionally, the government had
recently initiated a crackdown on illegal capital flows,
which probably worsened the short-term cash shortage.
Short periods of illiquidity are relatively common in
China, and not usually a cause for concern – the central
bank simply steps in to provide the necessary funds and
markets quickly return to business as usual. In this case,
however, the People’s Bank of China (PBC) refused to
step into the breach. Instead of injecting money, the PBC
sold a small number of three-month bills, swapping less
liquid assets into the economy. While the scale of this
market intervention was not significant, the intention it
signalled was – the authorities were not going to rescue
banks this time.
Why did the PBC refuse to provide
liquidity?
Instead, the PBC showed its determination to make
banks comply with orders to reduce the amount of
credit sloshing around the Chinese economy. Many firms
have invested heavily in the years since 2009, in some
cases creating capacity for which there is no market
demand. Ship-building firm Rongsheng finds itself
with yards sitting empty, struggling to pay its workers,
while steel and concrete plants sit unused. As the pace
of growth slows, it is clear that in some cases Chinese
industry has got ahead of itself – investing before there
was demand to justify it. From the viewpoint of the
authorities, this sticky situation is the fault of the banks,
who have issued too much credit to too many dud
projects. The PBC set an explicit target for money supply
growth, which implies a particular rate of credit growth.
If banks overshoot this and then find themselves short of
money, so the logic goes, they have only themselves to
blame.
icaew.com/economicinsight
cebr.com
30
20
1,000
10
0
0
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Q1
Q1
Q1
Q1
Q1
Q1
Q1
Q1
Q1
Q1
Q1
social financing, four quarter moving average
bank loans, four quarter moving average
social finance as a percentage of nominal GDP
Source: Chinese National Bureau of Statistics, Cebr analysis
While pre-crisis, most lending was through bank loans,
the growth of credit since has been set apart by
the development of the ‘shadow banking’ sector –
non-traditional banking activities which are less intensely
regulated and involve a greater degree of risk, often
carried out by hedge funds and private equity groups.
Two factors combined to encourage this. Firstly, a cap
on the interest payable on bank deposits has driven
investors into alternative assets as they seek out higher
returns. Secondly, strict limits on credit provision have
encouraged banks to move certain types of loans off
their balance sheets and into Wealth Management
Programmes (WMPs) – not dissimilar, in some ways, to
the collateralised debt obligations which proliferated in
Western banks before the global financial crisis. These
investment vehicles – in effect a form of regulatory
arbitrage – group together a range of assets. Some, such
as government bonds and interbank loans, are less risky,
while others, including loans to local governments and
property developers are much more so.
economic insight – Gre ater Chin a
Q3 2 013
Wealth Management Programmes offer returns of around
5% – far more than the 3.3% maximum available on bank
deposits, making them almost irresistibly attractive to
those with cash to invest. The combined value of WMPs
rocketed to reach 8.2 trillion yuan at the end of March –
an eightfold increase over the last four years, according to
government data. There appears to have been a further
surge in demand over the past few weeks, with Benefit
Wealth, a Chengdu-based consulting firm, suggesting
that a record 1,137 WMPs were sold in the two weeks to
28 June – an increase of about 50% over the first half of
the month. Despite their popularity, however, there are
serious concerns about the long-term viability of such
products.
Most WMPs have a short lifespan – about three-quarters
mature in less than six months, according to Fitch Ratings.
This creates a problem of maturity mismatch, where the
investment vehicles mature long before the underlying
assets. With more investors buying in, financial institutions
need more cash to pay off maturing products – meaning
they either have to borrow on money markets or issue
new products. If liquidity dries up, WMPs could quickly
begin to fail.
Moreover, as the Chinese economy slows, it is highly likely
that some of the underlying assets will fail to perform,
leaving financial institutions counting the cost. A lack of
transparency about the assets underlying WMPs and poor
understanding of the risks involved add to the potential
for market upset. Many investors struggle to distinguish
between WMPs and time-deposits, despite the fact that
70% of WMPs do not guarantee their premiums. If the
products should fail, the clamour from investors may
force Chinese banks to offer compensation – meaning the
bank’s liabilities could be far larger than expected. The
China Banking Regulatory Commission has taken some
initial steps to reduce risk in the WMP market, by capping
investments in non-standard assets, banning pooling
of assets and requiring banks to isolate the risks of such
investment vehicles from other operations, but the risk
from bad loans remains a serious concern.
How did bad loans become a problem?
China has an extraordinarily high level of credit for its
level of development, as illustrated in Chart 3. South
Africa, for example, has roughly the same level of GDP
per capita as China, but net domestic credit (a measure
of total credit to both government and the private
sector) is worth just 80% of GDP, compared to 155%
in China. China’s leverage levels are more comparable
to those of an advanced economy – although the US,
France, Germany and Australia all have lower levels of
net domestic credit, despite their much higher levels of
development. Moreover, in the People’s Republic credit
expanded rapidly after the financial crisis, from 121% of
GDP in 2008 to 145% in 2009. While many emerging
markets, including India, Brazil and Turkey increased
domestic lending at this time, China’s expansion of credit
was by far the most dramatic.
Chart 3: Net domestic credit as a percentage of GDP
and GDP per capita
%
250
Net domestic credit as a percentage of GDP, 2012
Banking innovations ramp up risk in
China’s financial sector
Japan
Spain
200
UK
Hong Kong
Italy
China
150
South
Korea
Australia
France
Germany
Thailand
Brazil
100
US
South Africa
Chile
India
50
Turkey
Kenya
Russia
Mexico
0
0
10,000
20,000
30,000
40,000
50,000
60,000
70,000 80,000
2012 GDP per capita, US$
Sources: International Monetary Fund, World Bank, Cebr Analysis
This credit fuelled the massive expansion in investment,
which supported GDP growth as global demand slumped
and net exports collapsed, as illustrated in Chart 4.
Investment became increasingly important to the Chinese
economy as its contribution to growth surged, and it now
accounts for fully half of the country’s GDP. With so many
resources seeking opportunities, it is inevitable that some
have not been allocated wisely. While Chinese credit has
been growing twice as fast as GDP, the marginal return
on every yuan lent has fallen dramatically. In many cases
there is simply not demand for the capacity that has
been developed. This trend has been encouraged by the
preferential treatment large state-owned enterprises face
in gaining credit, which has encouraged enormous levels
of investment in heavy industries like steel, aluminium,
solar panels and ship building. Unfortunately, the world
simply isn’t growing fast enough to provide custom for
these new production facilities. Other loans have been
used to invest in property, driving up prices without
providing a productive return. Worryingly, statistical
analysis suggests that over-investment of this sort is
positively associated with the probability of an economic
crisis.2
Poor investments and high leverage create
a perfect storm for markets
Most of this investment has been bankrolled by credit,
and where this is the case capital spending must bring
in additional income to pay off the loans. If these returns
fail to materialise, as no market is found for the goods
produced with additional capacity or land prices begin
to fall, the loans made to finance the investment must
be rolled over or written off; this can pose a risk to the
financial sector and broader economy. As it becomes clear
that China has developed excess capacity in certain sectors,
questions are being raised over the volume of loans which
will fail to meet their repayment schedules or are ‘nonperforming’. It is apparent that many of these loans are
being rolled over, avoiding the need for banks to write
them down as losses. As Chinese growth slows, however,
the country will at some point have to face its significant
debt burden.
More worryingly, China does not yet appear to have
weaned itself off its investment-led trajectory, with
icaew.com/economicinsight
cebr.com
economic insight – Gre ater Chin a
Q3 2 013
Q1
2010
investment
Q1
2011
Q1
2012
consumption
Q1
2013
net exports
Source: Chinese National Bureau of Statistics, Cebr analysis
Does China face a financial crisis?
China has overstretched itself with investments,
increasingly funded through the shadow banking sector
where lack of transparency increases the risk of contagion
in a crisis. There is the potential for a cascade of defaults
if growth slows suddenly, as the government attempts
to rebalance the economy or as a result of a natural
disaster, and the financial sector could quickly find itself
in difficulties. Considering the nature of Chinese overinvestment in comparison to other emerging markets
which experienced a crisis after a period of strong
investment-driven growth, recent IMF analysis suggests
that the chances of a crisis in China would be as high as
one in five.3�
In reality, the chance that China is running headlong into
a financial crisis is much lower than this. To begin with,
unlike the governments of some South East Asian countries
which were caught in the 1997-98 Asian financial crisis,
the Chinese authorities have the resources to bail banks out
if need be, thanks to a high level of existing savings and
foreign currency reserves, and the population’s remarkable
propensity to save. Not only is China’s debt relatively
low, but it is also largely held domestically – external
debt is only about 7.2% of GDP. This gives the Chinese
government far more power to deal with any financial
difficulties than the governments of advanced countries,
which rely on the support of their foreign creditors.
Chinese firms and local governments have mostly
borrowed from the Chinese people, and while a spike in
defaults would have serious political consequences, there
is no doubt that it could be resolved. The government
has also already indicated its willingness to bail banks out,
having spent 483bn yuan recapitalising lenders since 2003
and wiped out 1.4 trillion yuan of bad loans.
In all likelihood China’s current credit bubble will be
deflated gradually, but there are risks to this. While the
ratio of non-performing loans is likely to rise from its
current level of 1%, these defaults are unlikely to create
significant disruption in the wider economy. Growth will
slow, however, as the economy engages in a corrective
period, with lower profits.
One reform that would achieve all of this is the
liberalisation of interest rates paid on deposits. This would
drive rates up, obliterating the need for investors to seek
returns in the shadow sector. Liberalising interest rates
would also increase the rates State-Owned Enterprises
(SOEs) face, forcing them to confront the true costs of their
inefficient investments. While setting limits on credit to
politically-powerful SOEs could be politically impossible,
liberalising interest rates could provide the authorities with
a neat solution to the problem of SOE borrowing.
Developing capital markets will provide
another source of finance for firms
Chinese businesses would also benefit from a focus on
developing the country’s capital markets. At present, a
lack of stock market depth forces companies to depend
on banks for lending, limiting their options particularly
in the face of government restrictions on the volume
of loans. Poor returns have also played a role in driving
investors into the shadow banking sector. Although China’s
stock market is relatively well capitalised in comparison
to other emerging markets, as shown in Chart 5, current
regulations prevent it from growing faster. The state retains
control over initial public offerings (IPOs), constituting a
serious barrier to market access. The current quota system
of access to the exchange means some companies listed
are of questionable quality, while other firms with stronger
credentials find themselves unable to list.
Chart 5: China’s stock market in perspective
%
160
140
120
100
80
60
40
20
0
Poland
Q1
2009
Chile
-6
Germany
-4
Brazil
0
-2
Despite the risks inherent in the shadow banking sector,
it has played an important role in channelling funds to
smaller enterprises which would otherwise struggle to gain
credit. Any reform to try and reduce risks by increasing
transparency and bring money back onto balance sheets
must be offset by actions to encourage lending to these
firms.
France
2
Japan
4
Thailand
6
China
8
UK
10
South Africa
12
As part of its drive to rebalance the economy, the government
must ensure that incentives discourage investment where
it is unlikely to be productive. At present, lending is biased
towards large state-owned enterprises, although these often
lack the dynamism of smaller firms. Local governments also
face perverse incentives at present to invest in projects they
know will not generate returns, as this provides an instant
boost to the area’s GDP, increasing chances of promotion for
officials. The central authorities must consider carefully how
they can prevent distortions of this type.
South Korea
Chart 4: Relative contributions of sectors to China’s
GDP growth rate
Let markets decide which investments are
worthwhile
US
investment’s share of GDP ticking up in the second quarter
of 2013. If existing investments are already failing to
provide returns, channelling further credit-based resources
down this path is unlikely to prove fruitful, and may spell
trouble for the economy in the medium term.
Stocks traded, total value (of GDP)
Source: World Bank, Cebr analysis
icaew.com/economicinsight
cebr.com
economic insight – Gre ater Chin a
Q3 2 013
As an initial step, relinquishing control over IPOs would
allow the market to judge the credit worthiness of firms
and provide another way for businesses to seek finance.
Further liberalisation of the Qualified Foreign Institutional
Investors (QFII) programme, to allow foreign companies
greater access to financial markets, could both increase
the supply of capital available to firms and encourage
innovation, spurring the maturation of China’s capital
markets.
Chart 6: Greater China GDP growth forecasts
%
10
8
6
4
2
Efforts to ease the credit cycle will
constrain growth across Greater China
Early indicators of economic conditions continue to
suggest that Mainland China is slowing in 2013.
Investment continues to drive the economy, but as returns
fall so must the pace of expansion. Furthermore, with
much of this investment fuelled by credit, an increase in
the number of non-performing loans will derail the growth
train. While in all likelihood the People’s Republic will
avoid a hard landing, the careful management needed to
avoid this while rebalancing the economy from investment
towards consumption will affect growth.
As investment growth slows, domestic consumption will
continue to increase, propelled by rising wages – the
12th five-year plan set the goal of an annual minimum
wage increase of at least 13%. Economic prospects should
improve next year with the US expected to hit growth of
2.5% and the eurozone finally emerging from recession,
kicking the global economy into recovery mode and
boosting Chinese exports. Neither consumption nor
exports are likely to grow fast enough to compensate for
stagnation in investment, however, and so growth is likely
to edge downwards in the short run.
Although the PBC has boosted liquidity in markets since
June, banks are likely to have become more cautious as a
result of the squeeze. While the government could step in
with fiscal stimulus to support growth, statements from
Premier Li Keqiang suggest that if this does occur it will
be on a much smaller scale than in previous years. This
and a sweep of negative leading indicator data have led
us to reduce our growth forecast for 2013 to 7.2%. The
pressures of rebalancing the economy lead us to expect a
further deceleration in growth to 7.0% in 2014 and 6.8%
in 2015.
0
Mainland
Hong Kong
2013
2014
Macau
2015
Source: Cebr
Hong Kong’s GDP growth will be constrained this year as
the global economy remains subdued. Slowing growth in
the Mainland will also restrict the Special Administrative
Region’s (SAR) expansion, although the economy could get
some benefit from the liquidity squeeze in China through
its position as the main external market for renminbi. In
2013 growth of about 2.9% is expected. As the eurozone
eventually begins to recover in 2014 and the US overcomes
its fiscal tightening, the SAR should see prospects pick up
in 2014, with the rate of output expansion accelerating to
around 4.0% before moderating to around 3.7% in 2015.
Growth in Macau is tightly tied to that of its larger
neighbour, and as China struggles to rebalance Macau is
likely to feel the pinch. Things may be slightly less bad than
previously feared, however – the new Mainland
administration has yet to restrict travel to the SAR, and
gambling revenues continued to grow strongly in the first
four months of the year, with hotels running at 95%
occupancy. The liquidity squeeze and wobbles in Chinese
financial markets are likely to reduce the amount of money
gamblers are willing to spend in the second half of the
year however, leaving growth over 2013 as a whole at
8.0%. Investment in new casinos and rising wages in China
are likely to push growth up to 8.6% in 2014 and 9.2%
in 2015.
1 Total
social financing includes bank loans (both renminbi and foreign currency), trust and entrust loans, bank acceptance bills,
corporate bond financing, and other funding sources such as insurance, micro lending and industry funds. This is a flow concept,
showing the net increases in each component over a given period.
2 Il
Houng Lee, Murtaza Syed and Liu Xueyan (2012), Is China Over-Investing and Does it Matter?, IMF Working Paper WP/12/277
3 Ibid.
icaew.com/economicinsight
cebr.com
economic insight – Gre ater Chin a
Q3 2 013
For enquiries or additional information, please contact:
Vivian Yu
T +86 10 8518 8622
E [email protected]
Cebr
The Centre for Economics and Business Research is an independent consultancy with
a reputation for sound business advice based on thorough and insightful analysis.
Since 1993 Cebr has been at the forefront of business and public interest research.
They provide analysis, forecasts and strategic advice to major multinational companies,
financial institutions, government departments and trade bodies.
ICAEW is a world leading professional membership organisation that promotes,
develops and supports over 140,000 chartered accountants worldwide. We provide
qualifications and professional development, share our knowledge, insight and
technical expertise, and protect the quality and integrity of the accountancy and
finance profession.
As leaders in accountancy, finance and business our members have the knowledge,
skills and commitment to maintain the highest professional standards and integrity.
Together we contribute to the success of individuals, organisations, communities
and economies around the world.
Because of us, people can do business with confidence.
ICAEW is a founder member of Chartered Accountants Worldwide and
the Global Accounting Alliance.
www.charteredaccountantsworldwide.com
www.globalaccountingalliance.com
ICAEW Greater China
Room 706, Tower E1, Oriental Plaza
No.1 East Chang An Avenue
Dong Cheng District
Beijing100738, China
icaew.com/china
ICAEW
Chartered Accountants’ Hall
Moorgate Place
London
EC2R 6EA UK
icaew.com
© ICAEW 2013 MKTPLN12406 08/13