Concern about China’s financial system has been growing more acute. Indeed, the view that a significant financial collapse, with global consequences, is likely in China in the not too distant future is now bordering on consensus.
In May The Economist published a special report on the issue, entitled The Coming Debt Bust. The report contained a series of articles that echo the growing concern, broadly concluding that China is well down the road to a financial crash with wide-ranging negative consequences for economies and financial markets around the globe. This concern has since deepened in the wake of the UK referendum result.The argument is straightforward and eerily reminiscent of the pre- and post-Lehman experience across much of the developed world.
Simply put, in response to the global financial crisis, China dramatically expanded debt via its banking and shadow banking system. While this was broadly successful in cushioning the economy from the negative fallout of the crisis, the debt overhang has left the banking system and the broader economy increasingly vulnerable to a growing tide of problem loans.
The numbers look compelling. China now has the biggest banking sector in the world, with assets equivalent to 40% of global GDP. Meanwhile, total debt-to-GDP has climbed from 155% to nearly 260% since 2008.
More worryingly, with roughly two-fifths of new debt currently swallowed by interest on existing loans, China’s debt burden is becoming increasingly difficult to service and problem loans are growing sharply.
The Economist’s sobering conclusion was as follows: “When the debt cycle turns, both asset prices and the real economy will be in for a shock.”
My view is that the conflation of the pre- and post-Lehman experience of the developed world banking system and that of China today is flawed.
Such a view overlooks the fact that the Chinese financial system, and its relationship to the broader economy, is fundamentally different by design. More importantly, the differences suggest that the growing concerns will prove unfounded.
Notwithstanding the tentative steps towards capital account liberalisation in recent years, the exposure of the Chinese economy to foreign currency risk is non-existent.
Unlike its Asian counterparts during the 1997 financial crisis, or the UK in 1992, China retains the power to settle its debts. Gross foreign currency external debt is a mere $800bn (€727bn) and is covered by the stock of foreign exchange reserves of $3.2 trillion.
The party/state retains control of how and when debt contracts are settled across the economy.
In practice, the key difference in the standard banking relationship between China and the developed world is that a single entity — the party/state — is on both sides of the relationship.
The party/state is effectively both the borrower and the lender via its dominance of the non-bank economy combined with its control of the banking system.
Decisions as to if, when and where problem loans are allowed to occur and have an impact are therefore political ones.
In China, it is the opaque priorities of the party/state rather than the evolution of the credit cycle that determine the outcome.
The likelihood of this power being used to cause a banking crisis is akin to a decision by the authorities in America to default on US Treasury debt.
In both cases, such a decision would be unnecessary and inexplicable — why would policymakers choose to cause an unnecessary crisis?
In the context of Chinese banks, there is growing consensus of a high probability of the kind of financial crash predicted by The Economist. However, while investors are discounting a severe credit cycle, they are ignoring the power of the party/state to manage and control such a threat.
This is an opportunity we should be happy to exploit. As part of a broadly diversified and conservatively valued portfolio, stocks such as China Construction Bank, ICBC and Bank of China, which offer dividend yields of almost 8%, should be considered.