With Economic Pressures Mounting, Expect A Year Of Transition In China

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 |  Includes: CHLC, CN, CXSE, DSUM, FCA, FXI, FXP, GXC, MCHI, PGJ, XPP, YANG, YAO, YINN, YXI
by: Invesco US

Summary

China is transitioning this year from an investment-led economy to a consumption-led economy, against the backdrop of growing concerns about credit quality pressures.

We believe the Chinese government has the capacity to initiate growth, resolve asset quality issues and maintain its support of state-owned enterprises.

Economic and financial system policy reforms, we believe, are necessary in China as the country integrates more deeply with Western financial markets.

By Joe Madrid

This will likely be a year of transition for the Chinese economy, as the central government attempts to rebalance from an investment-led to a consumption-led economy - against the backdrop of growing concerns about credit quality pressures. We believe the necessary economic and financial system policy reforms will likely be implemented and that they are absolutely necessary as China integrates more deeply with Western financial markets.

The rise of 'shadow banking'

To understand the current concerns about China's economy, we need to first look back at its massive credit growth since 2008. Credit creation during this period totaled around $14 trillion, which is roughly the total size of the U.S. banking system. This surge in lending, combined with a four trillion renminbi government stimulus package, helped China sidestep the global contraction following the 2008 financial crisis, resulting in GDP growth of 9.2% and 10.4% in 2009 and 2010, respectively.

But it came at a cost. China's total debt levels increased to 220% of its GDP by 2013. Moreover, during these boom years, official bank lending practices, including regulations that capped the loan-to-deposit ratio at 75%, started becoming a constraint for some borrowers, including local governments and property developers. Increasingly, borrowers turned to financing outside of the official banking sector - a practice sometimes referred to as "shadow banking."

But as China's nominal GDP growth began to slow and the red-hot property market cools, the efficiency of shadow bank lending has come into question, particularly as non-performing loans begin to rise. Also raising concern among investors was China's first onshore bond default, which occurred this March when solar cell maker Shanghai Chaori failed to pay interest on its bonds.

Although the ultimate level of China's troubled debt will be difficult to estimate, we believe that non-performing loans are most likely sizably higher than 1% of total bank loans, as currently reported.

Government intervention

As the situation in China continues to unfold, we believe the government possesses many levers to initiate growth, resolve asset quality issues and maintain its support of state-owned enterprises, as needed. The Chinese government has been proactive thus far in restructuring targeted industries and entities that have needed assistance, and we believe that with a high level of foreign reserves and healthy government finances, the government will be able to provide the necessary financial support. We believe this suggests that there's a greater probability that a credit crisis - should it occur - will most likely be confined to a domestic rather than a global event. Over the long-term, this kind of shake-up in the credit environment could lead to:

  • Greater market discipline
  • Pricing that more accurately reflects the true underlying credit risk
  • Improved capital allocation due to pricing discipline

The challenge for the Chinese government, we believe, will be to carry out such reforms while ensuring China's social stability and supporting economic growth - all without triggering a destabilizing default cycle.

Sources

  • Fitch Ratings, Chinese Banks Special Report, September 18, 2013.
  • Bloomberg L.P.

About risk

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer's credit rating.

China remains a totalitarian country with the following risks: nationalization, expropriation, or confiscation of property, difficulty in obtaining and/or enforcing judgments, alteration or discontinuation of economic reforms, military conflicts, and China's dependency on the economies of other Asian countries, many of which are developing countries.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

NOT FDIC INSURED MAY LOSE VALUE NO BANK GUARANTEE
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