Negative Outlook for China Economy, Fixed Investment and Key Global Linkages

Negative Outlook for China Economy, Fixed Investment and Key Global Linkages

The large growth in credit over the past five years has led to a massive capital misallocation. There exists widespread evidence of a significant capital stock surplus in certain sectors, such as residential- and commercial-property.

Chinese fixed investment has averaged 50% of GDP over the past five years, an unprecedented level relative to other economies both past and present.

Chinese fixed investment spending has been a major driver of global demand for industrial commodities, particularly steel and iron-ore. A substantial slowing in Chinese fixed investment spending creates substantial downside risks for industrial metals

Low global interest rates and access to cheap US Dollar funding has led to the large-scale use of cheap US Dollar funding to finance risky investment projects in China. Unwind of this trade could lead to systemic risks in certain key banking centres, such as Hong Kong and Singapore and Australia by association.

Detailed Insight

Fixed investment expenditure has averaged between 40% and 50% of Chinese GDP over the past five years, an extraordinarily elevated level when compared to the global average of around 20%. Developing nations transitioning towards a more developed economy often have sustained cycles of elevated fixed investment expenditure as they build out the capital stock required to maintain a developed economy. Japan and South Korea have been two of the most notable examples in the last 40 years. However, even in these cases, fixed investment only reached a level of between 30% and 40% of GDP. The high level of Chinese fixed investment, supported by substantial credit growth relative to GDP are classic signs of an investment boom that has become excessive, fuelled in part by cheap funding and credit growth. The country’s capital stock, particularly in the property sector, is now significantly overbuilt relative to current levels of consumption.

The unbalanced growth dynamic in China and overinvestment in capital stock has been supported by the country’s large trade surplus, capital inflows and the fixed-exchange-rate regime, which has created a virtuous positive feedback loop. A fixed-exchange-rate regime, in tandem with a trade or current account surplus, requires the domestic central bank to purchase large quantities of foreign exchange. To the extent that these purchases cannot be sterilized, this leads to a rise in bank reserves and expanding credit- and money supply. This was the initial impetus for the credit and investment bubble in China.

A fixed-exchange-rate, to the extent that it can be maintained also often, leads to interest rates remaining artificially low, which further stimulates reckless lending. This can lead to a large rise in asset prices, which further encourages the expansion of credit. This is the second phase of the bubble. However, the unique global external backdrop since 2008, characterized by essentially zero short-term rates in the major developed economies, led to another or third phase of the bubble in China. Low or zero US Dollar interest rates encouraged the development of a large-scale carry trade, with onshore Chinese companies and financial institutions obtaining cheap US Dollar funding. This was to speculate in the Chinese property market or extend risky loans at much higher rates to small and medium-sized businesses. The fixed-exchange-rate ensured that this carry trade had little currency risk attached to it.

Despite capital controls that prevent onshore Chinese companies from directly obtaining foreign currency loans for non-trade purposes, some data suggests that the outstanding USD-denominated debt owed by mainland Chinese entities could amount to as much as USD 1trn. With USD interest rates close to zero, and returns from investments in real estate etc historically providing close to double-digit returns, this has proved an extremely lucrative trade.

However, with China’s debt levels mounting and non-performing loans increasingly difficult to hide, it has become more challenging for the Chinese economy to continue creating more credit, which is crucial in order to prevent a consequent deleveraging. At some point, however, the total debt load relative to GDP will become so large that it may become difficult for the economy to service this debt load in the event of a rise in interest rates. As we have discussed, for various reasons we expect global interest rates to rise, perhaps fairly substantially over the next five years.

In China’s specific case, it can control and maintain low domestic interest rates as long as it is able to maintain a trade and current account surplus and positive capital account (capital inflows). We have previously detailed the sharp rise in Chinese labour costs, which has already substantially eroded China’s competitive position to some extent. Rising global interest rates may also result in a reversal of capital flows as the carry trade cited above unwinds out of China. Should this happen simultaneously with a reversal in China’s trade surplus to a deficit, China will lose the ability to maintain low domestic rates.

These dynamics suggest that when the tide turns (global rates rise and/or China’s current/capital account moves to a deficit), there will be little Chinese policymakers can do to avoid an inevitable rise in interest rates, followed by an  unwinding of the carry trade and likely deleveraging. Although state control of the banking sector will likely prevent an acute banking crisis in contrast to the case in the US in 2008 and social spending could maintain consumption rates, it may be difficult or impossible for China to maintain its current rate of fixed investment spending. This is where the greatest risk lies from an eventual deleveraging in the Chinese economy.

A sharper than anticipated slowdown in Chinese fixed investment, which still accounts for roughly 50% of total Chinese GDP, is a particularly ominous development for commodity markets, as fixed investment is typically commodity intensive. This is particularly relevant for the base and ferrous metals complex at a time when these markets also appear to be facing growing supply. Apart from the risk to commodity markets, the potential for a disorderly winding of the carry trade could still negatively impact on Asian banking systems closely tied to China, but without the same backstop as the mainland Chinese banks, specifically those in Hong Kong and Singapore.

Hong Kong – Epicentre of the Carry Trade into China?