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The

China Path by Matthew Garrett (

11/07/15

@mattgarrett3)


Intro-
Over the last 12 months weve witnessed a steady barrage of transformative events out of
China, each on their own are hugely significant but together become a hard to untangle ball
of string. I will highlight some of the recent events and build a context to help shed light on
what is likely to happen next in terms of policy, economic transition and market impact.

I.

The Context

China is entering a new phase of its economic lifecycle after accumulating massive
amounts of debt in its investment centric economic regime. The recent pace of investment
and subsequent leveraging accelerated greatly in reaction to the Global Financial Crisis
(GFC) and more recently has seemed to hit its upward bound as more than a full turn of
leverage has been added to the economy in the last few years. In fact the rate of new debt
issuance has reaccelerated while GDP growth drifted to lower rates.

These two trends are the broad indicators or symptoms that are showing that the Chinese
economy, in its current form, is on an unsustainable and dangerous path. However, things
start getting interesting when drilling down a level, and a path forward for policy emerges.

The build up in debt has been unprecedented in size and speed. From 2007 to 2Q14 the
total debt level and as a percent of GDP increased by $20.8T and 124 percentage points,
respectively (chart 1). This accounted for more than 36% of the $57T of debt added
globally over this period (chart 2).

SOURCE: McKinsey Global Institute



Much of this credit growth funded investment in large infrastructure and real estate
(RE) projects as part of the stimulus after the GFC. Some of which went to projects that
could easily be considered malinvestment (image 1). The construction naturally led to a
surge in demand for imported materials, boosting sectors levered to materials
exporting (chart 3).

SOURCE: CHINAFOTOPRESS/GETTY IMAGES



SOURCE: Bloomberg

Pockets of Leverage

Corporates

Chinas massive leveraging by and large has been concentrated in a few sectors of the
economy. China is home to the biggest corp borrows with $15T of debt outstanding
representing 150% of GDP as of 2014 (chart 4). The pace of this corp leveraging
(change in corp debt as % of GDP) leads the EM pack (chart 5).

SOURCE: HSBC

SOURCE: IMF

Within the corporate sector the largest share of debt has been concentrated within RE &
construction, and manufacturing. Drilling down another level, it is a handful of the
largest firms that have issued the bulk of the debt within these industries (chart 6).
This is reflected in both absolute terms and relative terms when looking at leverage
ratios (liability to equity ratio) among the firms (charts 7-10).

SOURCE: IMF

SOURCE: IMF

Local Governments

The other post GFC large borrowers were the local governments (LG), accumulating
debt at 27% per year from 2007-2Q14 according to a McKinsey Global Institute report
published earlier this year (chart 11). The latest statistics, through 2014 show total LG
debt at $3.7T or 38% of GDP according to Moodys. The run up in this debt has been the
direct result of policy response to the GFC compelling the policy banks and regional
banks to lend to the LGs for infrastructure and development projects. This lending
mostly took the form of Local Government Financing Vehicles (LGFV). In this construct
the LG pledged assets (land, cash, SOE stake, etc.) to the LGFV, the LGFV would in turn
raise capital (bank loans, trust products, bond market) to fund an
infrastructure/development project. This construct amounted to regulatory arbitrage,
as LGs were restricted from direct borrowing.

SOURCE: McKinsey Global Institute

While the LG debt is dwarfed by corp debt, LG debt has some hair on it. This is largely
credit and market structure issues. On the credit side LG financings are limited to being
secured and repaid by property sales. This is the result of limited taxing authority at the
local level as well as the central government having claim on 50% of income taxes.
Finally, these are largely unregulated structures and lack standardization. As this paper
nears maturity and needs to be rolled, risks exist, as funding sources are not well
established. This is has caused policy makers to make a big push to get the municipal
bond market up and running (with a few rescues of this effort along the way).

The less levered Sectors

The household sector has a relatively low level of debt when compared to the other
countries at about 38% of GDP at less than half of that of the US and South Korea. The
largest portion of this debt is in the form of mortgages (another linkage of debt to RE).
The Central Government also carries a low debt burden at about 26% of GDP.



In the wake of leveraging via underdeveloped capital markets China as a whole has
relied heavily on loans for sources of investment capital, which represent 72% of debt
outstanding, by official numbers (chart 12). A lot of this comes via opaque and
fragmented shadow banking channels (chart 13). There are also the serious issues of
moral hazard and weak bankruptcy procedures. These all amount to impediments for
effective allocation of capital and transmission of monetary policy.

Note: Debt numbers do not represent total debt but are the sum of official statistics on RMB bonds (from the
Asian Development Bank) and RMB loans from Financial Institutions (from the National Bureau of Statistics).

SOURCE: McKinsey Global Institute



Bonds make up only a small portion of the Chinas debt. This represents a disadvantage
in their aggregate capital stack but also an avenue for improvement.


Credit intensity and capacity are diverging. The amount of GDP growth generated for
a unit of credit created is declining (chart 14).

Data: Asian Development Bank, NBS

Looked at a different way, if China were to hit its growth numbers (6.5%) and Credit
growth were to moderate (10% - well below trend) total debt to GDP would be about
350% by 2020.


II. Recent Signals Reveal a Path Forward


China Inc is in the midst of a major restructuring

There have been two systemic level recapitalizations taken on this year. First, the PBoC
and MoF recapitalized the policy banks in excess of $60B and meaningfully larger than
initial estimates. Second, is the recapitalization of LGs that Ill cover below.

A new aggregate capital structure is being pivoted towards and is greatly changing
their financings and market structure. The pivot here is towards relying more on equity
capital, a shift towards more bond issuance and developing the securitization market.

1) Stabilizing the equity markets so corps can issue new equity to reduce the stretched
balance sheets (charts 7-10).



2) Shifting towards more usage of debt securities in the form of bonds and
securitization. This is most notably happening with LGs tapping the bond market to
refi/swap out of maturing LGFVs and other LG debt. This required increasing levels
of PBoC easing and finally the inclusion of the newly issued bonds as collateral for a
standing lending facility. This should be viewed as a narrowly avoided disaster.

3) Expanding the balance sheet of different sectors of the economy. This is likely to be
the consumer, fitting with the stated policy objectives of the CCP to expand
consumption. By extension the industries that serve the consumer will expand as
well. The CG will likely lever up as fiscal stimulus or possibly any bailouts are
needed going forward.

4) Increasing the carrying capacity for debt securities (new sources of funding) by
broadening the investor base. This will happen internally via innovation and
regulation. Commercial banks and fund houses hold more than of these securities
(Chart 15). More significant is the continued development of the external market
(part of RMB Internationalization). China has issued very little external debt, as of
2013 less than 10% of GDP (chart 16). Coincidentally, this happens to be where
most of the action has been of late.

QFII, RQFII (program for foreigners to in invest in china) cap increases
Opening of foreign trading centers
Issuance of Central Bank and Govt securities (PBoC just issued $4.7B of 1yr
CB bills in London)
PBoC removed the quotas for foreign CB, SWF and some Institutional
investors holdings of bonds
The launching of CIPS or Chinas own international payment messaging
system for financial institutions. This is a competing system to SWIFT.

Source: DB

Source: IMF



A Reorganization of the Economy is the corresponding action to the market reforms.
The new capital will have to go to sectors of the economy that will have higher
multipliers and capacity to borrow (chart 17). As has been discussed this is the
consumer and services sectors. Both of these sectors carry relatively low levels of debt
and dont have the over capacity like the previous growth engines of the economy.
Additionally, the household (HH) sector in China has one of the highest savings rates in
the world at about 40% (Chart 18). Growth should continue to be lead by the Tertiary
or services sector currently at about 48% of GDP and growing at 8% at last read. As a
comparison, US and South Koreas services sectors represent 78% and 59% of their
respective GDPs.

Data: OECD

Source: HSBC


III.

A rundown and Conclusion

2015 has been a year where Chinas central bank has had to repeatedly alternate between
managing crises and averting disasters. Meanwhile, the longer-term plan has further
unfolded which is a transition to the services/consumer economy and a modernization of the
financial system. The end game here, if successful, is a transition where growth from these
emerging sectors is strong enough to overcome the drag from previous excess investment and
capacity. There does exist a real chance that the accumulated debt is too cumbersome to
bare, and a deflationary environment takes hold. This raises the question of what options are



left if this downside case comes to fruition after rates have been taken down to zero and RRR
cuts arent having sufficient impact.
The ultimate act in modernization (being ironic here) would be the final policy response to
a deteriorating situation and that is Quantitative Easing (QE). Ive heard people say the
PBoC is doing QE, but they are more in the alphabet soup of lending facilities phase of
easing. This is closer to where the FED was in 08 with TALF, TSLF, CPFF, etc. In fact
China currently isnt ready to utilize QE if it were needed. Many of the reforms mentioned
above put in place the dynamics for QE to be utilized in a similar way that the FED, BOJ and
ECB have. These dynamics are: 1) fully floating currency; 2) incremental external debt; 3)
issuing larger proportion of standardized gov and corp debt securities. All of which would
take time.
In the absence of significant incremental QE from Chinese or other CBs, these are
potential narratives.

1. Global rates rise as China starts competing for funds in global capital
markets.

2. Credit spreads are unlikely to go back to their post GFC tights. I believe they
can widen out further. Both based on credit cycle dynamics and the added
net supply coming from the east.

3. The china consumer comes alive (1.3B people), this is extremely important
given the worlds reliance on Chinas growth contribution.

4. Inflation- the conditions for a regime change in inflation trends exist. Part of
this scenario would include emerging inflation in pockets of the economy,
through nontraditional channels. But well save this for another day.

If Chinese growth were to fall further it would be sorely missed


Source: Macquarie

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