As the nature of China’s economic expansion changes, what will imbalances in its economy mean for Southeast Asia?
By Gareth Lewis
Having scaled the ladder to the upper rungs of China’s top trading partners, Asean has much to gain from its strong neighbour. Trade between the two is set to expand to $500 billion by 2015, as they strengthen ties amid a global slowdown. While government officials are keen to present a rosy outlook for bilateral trade volumes, a health check of China’s economy throws up a few surprises.
Since the 1980s, China has experienced a period of rapid economic growth, embarking on the industrialisation of its previously agrarian economy. Buoyed by cheap labour and a competitive exchange rate, China has become the world’s manufacturing centre. However, without the social safety nets associated with many developed economies, the Chinese have not responded to greater wealth creation through increased consumption. Instead they have saved cash at the expense of spending, creating an economy with an under-developed service sector and an over reliance on export markets and internal investment.
These imbalances went largely unnoticed in the pre-crisis period as Western economic demand sustained the market for Chinese goods. As this demand has weakened, the country has had to generate other forms of economic demand to sustain growth.
To achieve this, the ruling Politburo supported a series of infrastructure projects that successfully averted the worst of the downturn. However, rather than centrally funding these projects, credit availability for local authorities was increased, encouraging greater debt-funded development at the regional level. Projects as diverse as airports, roads and power plants were approved, and many authorities sought to fund them through increased land sales. As a result, the ensuing boom in infrastructure investment also had the secondary effect of promoting the country’s growing property bubble.
By 2011 China had been growing fixed investment by 13.5% per annum for a decade accounting for approximately 50% of GDP in 2012. Analysis by UBS estimates that a country at China’s stage of development should be running 30-35% investment to GDP ratios, suggesting that a proportion of recent growth has been uneconomically achieved. As a result, the rate of loan delinquencies has started to rise. By 2011, more than 20% of all loans extended as part of the 2008 package had been written off, while last year Chinese banks were forced to roll over at least three quarters of all maturing loans to local government. The resulting stock of outstanding local government debt stands at between $1.6 trillion and $3 trillion, equivalent to between 20% and 40% of the economy.
As bad debts have begun to mount, the authorities have placed increasing restrictions on mainstream lenders. In response, the ratings agency Fitch has downgraded China’s long-term credit rating to A- (from AA-), citing financial risks from the rapid credit expansion.
Despite the slowdown in official bank lending, wider credit growth has continued to accelerate as projects source finance from the shadow banking system. Tolerated and theoretically regulated by central government, the shadow banking system consists of a loose amalgam of off-balance sheet, trust and non-bank organisations. Last year more than 50% of all Chinese credit emanated from shadow banking, reflecting the sector’s ability to attract an increasing proportion of the nation’s savings. Unofficial figures suggest that in 2012 around $1.5 trillion was placed into products offered by non-bank financial institutions. This has resulted in an unmanageable expansion in Chinese credit growth. Total Social Financing (TSF), which includes normal bank lending and shadow banking, accelerated by 22% over the 12 months to March 2013, despite authorities calling for greater credit restraint.
Many of these ‘savings’ products are not all that they seem. With little or no regulation, many offer superior returns by making risky loans to fund local government projects or speculative housing development. The system is made more precarious through a mismatch in the duration of deposits taken and loans made. New ‘deposits’ are used to pay back the maturing products of earlier investors. As a result, large parts of the shadow banking system resemble a Ponzi scheme that operates with tacit support from authorities.
The pressures created by this are only too clear. The country’s major auditors are commenting on local government credit worthiness and are refusing to sign off on almost all new local government debt. Credit intensity has also risen sharply, suggesting that the current rate of GDP expansion is not sustainable. Lombard Street research suggests a growth rate nearer to 5% would be normal for an economy at China’s stage of development, while BHP Billiton – the world’s largest mining company – is basing its forecasts on GDP growth of 6% by 2014.
For the economies of Asean, the impact of slowing Chinese demand is harder to predict. The Asian region has materially increased export exposure to China over the last decade, helping to account for a large element of recent growth. However, if the US economy recovers as we believe, and dollar-based export markets improve, we would expect part of this impact to be ameliorated. Moreover, demographic trends and a rising middle class suggest that, for many Asian economies, their own internal rebalancing will be a major driver of longer term growth. The IMF suggests that a 1% decline in Chinese GDP would lead to a 0.6% hit to the most exposed regional economies of South Korea, Thailand and Taiwan. This is clearly material in the context of a region forecast to grow by between 5% and 6% this year, but it remains manageable.
Gareth Lewis is Chief Investment Officer for Bestinvest, an award-winning private client investment adviser with $7.5 billion of assets managed on behalf of private individuals, charities and pension schemes. In early 2012, Bestinvest partnered with Infinity Financial Solutions, the Southeast Asian focused Financial Planning Group, to provide an exclusive range of investment management solutions for Infinity’s clients. Bestinvest is set to present a series of investment seminars across Southeast Asia in partnership with Infinity Financial Solutions in June. To register for Bestinvest Asia Roadshow, please click here.