When looking at the growth rate of a country or company, you must also investigate how it is being generated to determine if the growth is sustainable. When analyzing China, some concerns surface.
Prior to 2008, growth in China was driven by exports and foreign direct investment, and companies benefited greatly from their access to a low-cost labour force. But when the credit crisis hit in 2008, consumption dropped dramatically in the Western world. To offset the shock, the Chinese government launched massive stimulus programs, funded by state-owned banks. Unfortunately, the spending was focused on driving growth and employment, not profit and returns.
Let’s look at some numbers from a recent CLSA report:
- New debt issued in China over the last four years amounted to 58.7 trillion renminbi (RMB) vs. 20.4 trillion RMB nominal GDP growth. That’s three RMB in new loans per one RMB of GDP growth.
- New debt issued in just four years is more than the entire GDP of China: 58.7 trillion RMB vs. 51.9 trillion RMB. The debt-to-GDP ratio is now over 200%, and quickly catching up to the U.S. at 250%.
- The balance sheet of the Bank of China has nearly doubled over the last five years to 30 trillion RMB (almost US$5 trillion). The bank's balance sheet now greatly exceeds that of the U.S. Federal Reserve at $3.4 trillion, even though the Chinese economy is only half the size.
Of course, debt isn’t always a bad thing, if it is invested in a productive manner and you earn more than the cost of the debt on your investment, you can service your loan, eventually pay off the debt and create economic value along the way. Unfortunately, in China, this doesn’t seem to be the case:
- Approximately 20% of the credit expansion from 2009-2012 went to local governments to fund projects with very long lives and questionable economic return. The debt-to-revenue ratio for local governments sits at 130% and when excluding land sales and transfers from the central government, this number is over 300%.
- Another large consumer of this credit was the state-owned enterprises (SOEs). SOEs are mandated to grow and keep people employed, not generate returns and profits. This is evidenced by their low returns on equity of 6-7% (which is even more of concern when you consider their high balance sheet leverage). It’s important to note the SOEs have preferred access to capital from the state-owned banks; if they had to borrow at market interest rates, profitability would be much lower, possibly negative.
- According to the IMF, average capacity utilization in China is roughly 60%, down from the high 70s in 2007. Anecdotally, we are hearing of overcapacity in a number of industries (LED, solar, steel, industrial batteries), driven by stimulus money in China. Even now, with these businesses uncompetitive and in many cases losing money, they cannot reduce capacity because they risk embarrassment and access to credit.
All of this could be contained in a command economy if funded by state-owned banks and the rich central government, which are willing to provide long-term funding without repayment. However, increasingly, the credit growth is funded by unregulated and off-balance sheet structures called Wealth Management Products, or WMPs. The risk lies in the fact that 90% of these products have maturities of less than six months. This mismatch of assets and liabilities could cause a serious credit crunch if the perceived risk of WMPs increases and this source of funding goes away.
In digging into the numbers, its clear that China’s growth drivers are a lot less sustainable than commonly believed. The combination of falling capacity utilization, increasing debt loads and marginal sources of financing in WMPs make the situation even more concerning.
At Cambridge, we focus on absolute returns and protecting the downside. While we continue to feel equities are attractive, especially relative to fixed income, we recognize China as a potential negative surprise to our thesis. Our bottom-up investing will continue to focus on areas with positive fundamentals (such as U.S. domestic growth) and we will maintain flexibility to raise cash if we feel the risk is being realized.