For all the undoubted long term potential of the Chinese economy and markets, there is plenty to be cautious about short term, and local sentiment at the moment is decidedly bearish.
The first and most obvious concern is China’s banking sector and the extremely rapid growth of credit in the system, together with a significant deterioration in loan quality. Debt has been rising much faster than GDP for at least the last six or seven years, so that accumulated debt in China is now well over 200% of GDP, comparable to many developed western economies, but still lower than in the Eurozone.
The next issue is to try to determine what percentage of loans are non performing. While there are various methods of defining ‘non-performing’, the most usual is a loan where interest payments are more than 90 days overdue. There are also questions regarding proper disclosure in an incredibly complex and formidably opaque system. Establishing how much debt exists to finance corrupt and unviable local governments is probably impossible for an outside party.
One authoritative estimate implies about 15% of loans are non-performing. On a historical basis this is not too serious, as this number has ranged between 5% and 20% for the last 10 years, with China’s strong economy generally allowing banks to delay the day of reckoning. But as the economy slows, that day will come. If a sustained slowdown can be postponed, the 80% or so of outstanding loans still generating a return for lenders may be enough to shelter the banking system from the worst excesses of defaults.
This is probably why the Government has moved to stimulate the economy, injecting more liquidity by reducing interest rates six times and reserve ratio requirements five times since late 2014, and easing up on reform of state owned enterprises (SOEs). The strategy has worked relatively well, although it seems that generating 1% of GDP now requires an extra 4% of credit, compared to around 1.5% pre-2008.
The bulk of the debt in China is attributable to SOEs, which account for 8 of the top 10 companies A-share listed debtors. If they don’t restructure they are assigned “special treatment status” and are liable to be delisted. The government is said to be heavily engaged in this process, so there is political pressure on banks to downplay the damaged status of many SOEs.
Local government debt is even harder to quantify, but generally if there are wholesale defaults, the ultimate responsibility rests with central government. While this is some comfort, such a scenario might still wipe out of the capital base of the banking system. One estimate suggests that if 20% of loans default, the capital base would be demolished.
More/…
Investors’ key hope is that Chinese corporates (even the non performing ones) revive, and that the economy continues to expand, even at the currently reduced pace. If this continues until say 2019, the profit generated by the sector is about 1.2x the assumed NPL figure, so the banks may be able to survive without having to raise a lot more capital, or be restructured.
So far in 2016 loan growth has been good, although net interest margins have fallen back to about 2.5%, in line with reduced interest rates, and look likely to decline to 2% next year.
This “muddle through” scenario may be too optimistic, and if so, it is hard to see a happy outcome. Debt to bond or equity swaps have been suggested, but NPL securitisation and other conventional options are new territory for China. Setting up asset management companies to take on the “bad bank” debt is not. In fact, they already exist, and may present a reasonable option.
While many of the banks do pay a dividend, this policy is likely to come under pressure. The sector trades on a price to book ratio of about 0.7x, so a bit of bad news is already priced in, but certainly not a major deterioration.
The overall conclusion is that the banking system is uninvestable but a ‘muddle through’ outcome which sees the sector survive, is plausible. The private sector is in good shape. It is the state sector where the worst problems lie, and where the national government will likely end up absorbing the losses.
For further information:
John Morgan – Fortuna AMC Ltd
Phone: +44 (0) 203 651 8925
Mobile: +44 (0) 7769 262272
Notes to Editors
About Aubrey Capital Management
Aubrey Capital Management – Website: https://www.aubreycm.co.uk/
Aubrey Capital Management Ltd is a specialist investment manager with a particular focus on global thematic conviction funds. Founded in 2006 and incorporated in Edinburgh, Scotland, Aubrey is a privately held company with all its shareholders actively involved in managing the business. The Aubrey team has collective investment experience of over 120 years in the UK, USA, Europe, Asia and Emerging Markets and an impressive track record of managing similar global funds in the past
Compliance Notes
This article is specifically provided for use by media representatives in the UK. The views expressed are those of the fund manager at the time of writing, and may have since changed.
This document has been issued by Aubrey Capital Management Limited which is authorised and regulated in the UK by the Financial Conduct Authority. You should be aware that the regulatory regime applicable in the UK may well be different in your home jurisdiction. This document has been prepared solely for information purposes and is not a solicitation, or an offer to buy or sell any security. The information on which the document is based has been obtained from sources that we believe to be reliable, and in good faith, but we have not independently verified such information and no representation or warranty, express or implied, is made as to their accuracy. All expressions of opinion are subject to change without notice.
Please note that the prices of shares and the income from them can fall as well as rise and you may not get back the amount originally invested. This can be as a result of market movements and also of variations in the exchange rates between currencies. Past performance is not a guide to future returns and may not be repeated.
Aubrey Capital Management Limited accepts no liability or responsibility whatsoever for any consequential loss of any kind arising out of the use of this document or any part of its contents. The use of this document should not be regarded as a substitute for the exercise by the recipient of his or her own judgment.