Opinion: Slowing growth and massive indebtedness in China threaten equity and bond investors around the world

The uproar surrounding the besieged Chinese group Evergrande, the world’s most indebted real estate company, is distracting attention from the larger Chinese debt problem and slowing economic growth.

China’s overall debt represented 270% of its GDP at the end of 2020, up from 247% a year earlier. External debt reached $ 2.4 trillion in 2020. Since 2008, Chinese borrowing, mainly from businesses and households, has increased by nearly 100% of GDP and represents two-thirds of the increase in global debt. Evergrande’s outstanding debt of over $ 300 billion represents less than 1% of China’s total debt.

Over the past 13 years, China’s growth has been driven by massive investments in government-funded and debt-financed infrastructure and real estate, mostly provided by state-owned banks. Part of this debt is tied up in low-yielding or non-performing assets that are unable to service borrowings.

This problem is not new. In 1993, 1998 and 2004, China successfully negotiated episodes of excessive lending to provincial governments and state-owned enterprises (“SOE”).

But this time it’s really different. The amounts involved are greater. Debt is private. External debt is significant.

Traditionally, China’s magic debt reduction machine has involved lenders transferring non-performing loans to asset management companies (actually bad banks) in exchange for government-guaranteed bonds. Then time and strong economic growth solve the problem. Rising GDP increases the value of assets, proportionately reducing the level of debt and NPLs in percentage terms to manageable levels.

But that time is now over. The required growth rates are now impossible to achieve. Given China’s current debt levels, which are increasing by around 12-15% per year, 6% growth is needed to simply keep debt-to-GDP stable. The problem is complicated by the Chinese government’s desire to reduce debt, which is the engine of growth. Growing trade tensions with the United States and denial of access to essential technologies are also hampering Chinese growth.

China’s financial flexibility is overestimated. Large foreign exchange reserves ignore accumulated investment commitments. Based on International Monetary Fund (IMF) criteria, China needs around $ 3 trillion, roughly current levels. The sums needed to recapitalize the financial system and restructure the economy would reduce them well below the IMF minimum. Given the large illiquid investments, such as Belt and Road Initiative loans and large holdings of US Treasuries, which would be difficult to sell and create unwanted appreciation for the CNYUSD yuan,
the realization of reserves can be difficult in any case.

The political challenge is great. The current crisis was sparked by attempts to restrict lending to real estate developers. Dealing with the legacy of poor quality loans today risks triggering a debt crisis and strangling economic activity. But not tackling the issues will result in a larger future problem and calculation.

Fear of social disorder and financial instability means government intervention is likely. With real estate accounting for 60-75% of Chinese household wealth, this will encourage public and other companies to take over projects to save unfinished apartment buyers and suppliers. Shareholders and lenders will suffer losses.

The main Chinese lenders will be protected. The country’s central bank will provide liquidity and keep rates low. Domestic savers can lose money on complex wealth management products. The heaviest penalty will come from artificially low or negative real rates. The transition from investment to consumption as China’s main economic driver will be delayed.

Global impact

Foreign investors are vulnerable. The prices of international bonds issued by Chinese real estate companies have fallen considerably. Ongoing economic disputes with the West, reduced reliance on foreign capital, and declining Chinese desire for economic engagement mean that defaulting on foreign loans is no longer a taboo.

Additionally, international lenders may not be able to access prime assets and cash flow due to convoluted lending structures resulting in significant losses. After years of berating China for ignoring market disciplines, foreigners can suffer the consequences of their own advice.

Since the Chinese economy accounts for around 30-40% of global growth, the slowdown will also affect China’s trading partners.

Investors in Chinese stocks and bonds, directly or through ETFs or emerging market funds, are at risk. Profits of US and European companies depend on Chinese markets for growth, leaving export-oriented companies, such as automobiles, industrial machinery, aerospace, technology and luxury goods, on display.

Producers of raw materials and raw materials like Australia and Brazil, and resource companies, all of which have benefited from Chinese demand, will see their revenues decline. Emerging market equity and bond investors, who have also benefited from Chinese trade and investment, are expected to experience ripple effects.

Obviously, what happens in China is unlikely to stay in China.

Satyajit Das is a former banker. He is the author of “A Banquet of Consequences – Reloaded: How We Got In This Trouble And Why We Need To Act Now”. (Penguin Random House Australia, 2021).

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