Why there's no hard landing in the pipeline for China

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The global financial community is almost uniform in its scepticism about China, which is rooted in the perception that China has several major economic problems, which will guarantee the long-awaited hard landing of the Chinese economy.

China's most serious problem, the narrative goes, is debt. The debt load is so excessive that China's economy is slowing. The slowdown in growth in turn explains why the stock market is so beset with volatility and frequent speculative frenzies.

Finally, all the aforementioned problems in turn give rise to the final problem: terminal capital flight. Since all the problems are interlinked, but ultimately rooted in the debt problem, which, everyone knows, is notoriously intractable, it follows that China's outlook is permanently bearish.

We disagree with this narrative. We do not accept that China has a fundamental debt problem to begin with. We do not believe that the other three problems are linked to debt.

We do not even see China's alleged 'problems' as necessarily problematic, because they are mostly symptoms of other developments many of which are actually fundamentally positive. We now explain these views.

DEBT

China's debt stock is large compared to other EM countries. China's stock of domestic credit to GDP is 256 per cent of GDP.

While this compares favourably to the 290 per cent credit to GDP average for developed economies it is nevertheless noticeably higher than the 155 per cent average for EM countries ex-China.

However, it makes no sense to look only at the lending side without also looking at the funding side. In China, the stock of deposits to GDP is truly massive: 197 per cent. This means that the banking system is only leveraged to the tune of 30 per cent (= 256 divided by 197 per cent).

The high level of deposits is a direct consequence of China's enormously high saving rate (49 per cent). The high level of deposits is actually a strength: deposits are the single most stable source of funding for banks.

Moreover, China's banks have extended most of their credit to infrastructure investment, which is likely to offer a higher return over the long term than, say, consumer loans in Western banks. Finally, China's debt stock is entirely sustainable given current growth and interest rates.

In sum, debt is not a systemic problem and should therefore not be regurgitated endlessly as the source of China's alleged economic problems.

SLOWER GROWTH

If debt is not the problem, why is China's growth rate slowing?

The primary reason for slower growth is that China is implementing an extremely ambitious reform programme, designed to rotate the entire economy away from state control to market forces, and away from an export-led focus towards a domestic demand-led growth strategy.

The magnitude of these reforms is such that consumers and investors have become far more cautious pending better information about their success (or otherwise). The postponement of investment and consumption is the principal reason for slower growth.

Investors should not be overly concerned, however. China's reforms are the right ones and are very likely to succeed.

Longer term, China will naturally grow more slowly, since a consumption-led growth model implies lower savings, lower investment and therefore lower real GDP growth rates. However, consumption will rise, so there will not be political unrest.

STOCK MARKET VOLATILITY

Chinese retail investors tend to invest in two types of assets (other than cash): property and equities. Both are bull-market instruments.

There is no obvious bear market instrument such as bonds available to retail investors, because nearly all the bonds in China are held by banks, pension funds and other institutional investors.

Where, in fully developed financial markets, investors would switch into bonds, in China the only way to trade a bear market is to sell stocks... and then to sell them again, that is, to short sell them.

China's stock market therefore tends to generate twice the volatility of developed economies with more broadly held fixed income markets.

Broadening the ownership structure of bonds in China is an important policy objective and China is making strides in this area with the development of the municipal bond market and rolling out mutual funds.

Soon China's onshore bonds will also feature in the most important global bond indices.

For now, however, it should be recognised that the volatility in the Chinese stock market is more a reflection of an underdeveloped fixed income market rather than a symptom of some deeper macroeconomic malaise.

In conclusion, China's growth is slowing due to reforms, not excessive debt. Stocks are volatile due to a combination of large volumes of savings and inadequate access to both bonds and foreign assets.

China's reforms are the right ones and the debt stock is sustainable. There is no reason to expect a hard landing.

Jan Dehn at head of research at Ashmore.


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