Leading investment strategist Tim Bond of Odey Wealth Management has warned that China is on course for a recession.
Bond is concerned about the build-up of leverage in China’s non-financial companies. He points to data compiled by the Bank for International Settlements, which shows that the private sector non-financial debt service ratio has risen close to 20%, similar to the levels reached in Europe and the US at the height of their credit bubbles. What’s more, the majority of new credit is being used to pay interest on existing debt or to finance continuing operations.
“It is plausible to argue that a system in which state-owned businesses borrow from state-owned banks, a Minsky moment (when markets refuse to further fund a debt bubble) can be staved off indefinitely. This might be true, but it is not the point.
“Rather, China is approaching the juncture at which additional increases in leverage will cease to have any impact on growth. This is due both to existing overcapacity and to the increasing proportion of fresh credit that is required to pay interest and fund continuing operations,” Bond commented in a note sent out to Odey’s clients.
This, he expects, will result in a “deep slowdown” in Chinese growth and the potential for a financial crisis.
Can China Switch to Consumer-Driven Economy?
Bond’s concerns have been echoed by the International Monetary Fund (IMF). Earlier this month, the organisation warned that China’s ballooning corporate debt, which rose to 237% of gross domestic product during the first quarter, could spark a bigger crisis unless the issue is addressed soon.
As we approach the second half of the year, China will no doubt continue to dominate the headlines as the authorities continue their efforts to stave off a slowdown and shift from an investment-led economy to one that is consumption-driven. Will they succeed?
Khiem Do, head of Asia Multi-Asset at Barings, suspects so. If the world had grown at a better rate and global trade hadn’t been impacted in recent times, he anticipates that China could have progressed further towards becoming a consumption-driven economy. In his view, China should be able to avoid a recession in the near-term.
“China has found itself in a situation where it would have liked to slow down its capital expenditure spending, but given that global trade has fallen off a cliff it had no choice but to intervene by resurrecting infrastructure projects, like building low cost housing,” Do explained.
Government Spending Still Drives Economic Growth
In Do’s opinion, the authorities would have liked to let the private sector and consumption drive the economy, but given the state of the global economy they have resorted to old capital spending programmes to support an economic growth rate between 5.5% and 6.5%.
Barings’ Asia multi-asset head acknowledges that the build-up of debt over the past seven years, post the property boom, is a concern over the longer term.
“Over the short-term, as long as the economy is growing and companies can continue to service their debt, I don’t think we are looking at a liquidity or banking crisis. There definitely has been a lot of debt built up and over the long-term the increasing number of non-performing loans needs to be addressed,” he added.
Kunjal Gala, a senior investment analyst on Hermes’ emerging markets team, views China’s debt to GDP levels at over 250% as a risk, particularly as it is second only to Japan. However, he agrees with Do that China can avoid a recession in the near-term.
“Although debt levels in China are high, a large part of the debt is in dollars, so there is not going to be a big run on the financial system in China like we saw in Europe a few years ago,” he said.
Investors should also not lose sight of the fact that China is a wealthy country with around $3.19 trillion in foreign exchange reserves, Gala added. The analyst remains positive that the continued process of urbanisation and improvements in living standards in parts of China can continue to support economic growth.
Does China Need ‘Big Bang’ Reforms?
“China is one country, but it is not one economy. A number of the economies in China continue to grow at a faster rate than the national average, which is why China has not fallen into a recession,” he explained.
During the second half of the year, Gala expects to see the authorities continue on their path of “mild stimulation” of the economy. This will buy them more time until they need to pursue “Big Bang reforms” to cut down overcapacity and reform zombie state-owned enterprises.
Against this backdrop, the analyst remains positive about China’s “new economy”, which refers to internet, technology, consumer-related and healthcare companies. These stocks can benefit as consumers continue to upgrade their lifestyles. Internet giant Tencent (00700), for example, has benefited from changing consumption patterns with revenue growth of 25%.
