Financial Industry Faces ‘Inventory’ Problem in China
China’s government has aimed to cut manufacturing overcapacity, boost demand for housing and reduce nonfinancial-sector leverage. While progress has been made toward the first two goals, it has actually moved further away from the third one and, as a result, created an even bigger risk to the economy.
This article examines the third problem from the perspective of financial institutions.
When you look at a balance sheet, deleveraging refers to a reduction in liabilities relative to equity for the company that borrows loans. For a bank that lends, it means its assets are not expanding as fast through a process involving the so-called derivative deposits, or deposits created when a bank makes loans.
If finance is compared to manufacturing, a financial institution’s products are the investments it makes. Before the funds are repaid, they should be viewed as “inventory” rather than completed sales.
From this perspective, China’s effort to reduce overcapacity and housing inventories over the past few years has been not so much about cutting overall debt levels as a continued shift of inventory from manufacturers and real estate developers to the financial industry.
Whether the financial industry would be able to digest and absorb the inventory depends on whether the economy can grow fast enough to keep the loans serviced.
This is a big challenge, given the current foreign and domestic conditions.
China’s nonfinancial-sector loans as a ratio of gross domestic product (GDP) has exceeded 270% by conservative estimates. Even at an interest rate as low as 4%, the annual interest payments on these loans would have amounted to more than 10% of China’s GDP.
In a closed system without additional funds becoming available for loans, the balance of capital supply and demand can be sustained only when the borrowers have high profitability, and when the savers have no better use for their funds other than lending them to earn interest.
The current economy does not satisfy these preconditions. The growth rate of sales at industrial companies has bounced back a little, but remained low at 4.9% last year. Meanwhile, the growth was driven to a large extent by a 9.6% increase in accounts receivables, suggesting deterioration in the companies’ ability to collect cash from sales.
Instead, the balance has been maintained so far by a continued supply of new loans. That’s why China’s overall leverage levels have been increasing despite the government’s effort to cut overcapacity and rein in credit bubbles.
But several changes in the macro economy and financial markets have made the creation of new loans much more difficult this year than in 2015.
First, the global monetary environment has changed with the U.S. Federal Reserve starting to raise interest rates. The continued depreciating pressure on the yuan has discouraged credit expansion inside China. Globally speaking, liquidity has become tighter, as private-sector leverage in emerging economies increased and offset the decline in developed countries.
Second, China’s own monetary policy has become notably tighter. The Chinese central bank has so far refrained from using the benchmark interest rate on bank loans and deposits to regulate interest rates. It has used open market operations instead to convey its tightening attitude on monetary policies, but there will be some time before the real economy feels the full impact of its move.
On the other hand, the slowed transition means the central bank may continue to make adjustments to liquidity policies over an extended period of time, resulting in greater overall impacts on the financial markets.
This is especially risky, given the maturity mismatches in many sectors. The bond market rout in December is an apt illustration of how deleveraging in financial institutions can occur abruptly and become contagious when liquidity was tightened.
Third, since June 2016, China’s financial regulators have taken coordinated actions to strengthen regulations for the banking, securities and insurance industries. Shadow banking, which has played an important role in previous credit expansions, now faces more restrictions.
These three points mentioned above are enough to significantly slow down this year’s credit expansion. Coupled with a weaker economy, they will lead to thinning cash flows and more expensive debts for many industry companies. This will, in turn, more likely trigger a credit crisis for the financial industry.
More importantly, when the financial industry goes into a crisis mode, credit expansion will be hindered. And even though the risk may not directly affect the manufacturing and real estate sectors, the economy will suffer, and those with high leverages will be particularly vulnerable.
There are signs that the process of credit expansion has already slowed down, albeit slightly. The government could choose to inflate away debts, let banks write down bad loans, or lower interest rates to give borrowing companies breathing room. Or it can solve the problem by boosting economic output, so companies have more profits to pay back loans. It would most likely choose a combination of these measures, for relying on any single one of them would not be enough.
Shi Lei is the head of fixed income research at Ping An Securities Co. in Beijing