With the threat of financial instability looming, China’s sustainable economic growth is at risk. Domestic leverage has reached 250 percent of GDP with heavy shadow banking activity, and the real estate sector is experiencing negative market sentiment and showing troubling indications that default levels will continue to climb. Limiting credit overcapacity while maintaining investment growth remains a challenging task for the People’s Bank of China as concerns rise that the property bubble could burst if credit standards tighten further.
Pace of deleveraging remains a major risk
As entrusted loan levels rose to a record high 455 billion yuan in December 2014 and margin trading also reached alarmingly high levels, China tightened its regulatory control over rampant shadow banking activity. The regulatory crackdown pushed stock prices downward, and the market showed increasing signs of volatility, with shares falling 7.7 percent within one day in January, the sharpest one-day slump in six years.
PBOC has injected funds into banks to calm worries and to prepare for the upcoming Chinese New Year holiday season. In addition to the recent 0.5 percentage point reduction in banks’ reserve requirement ratio, PBOC also cut 0.5 percentage point for banks lending to small businesses and 4 percentage points for the Agricultural Development Bank of China, which released a total of 600 billion yuan into the economy. FSG expects one interest rate cut in the second quarter and another possible cut in the second half of the year.
With a struggling real estate market and a contracting manufacturing PMI, a continuation of expansionary monetary and fiscal policy is needed to boost growth. This, however, would also raise concerns that by allowing banks to extend increased levels of credit the central bank will fuel even more debt, adding pressure to the volatile stock market and harming the country’s deleveraging efforts.
Effective financial restructuring is imperative
Reduced levels of non-performing loans and local government debts and a more stable property market are critical if China hopes to achieve a successful financial restructuring by 2020.
(Sources: Frontier Strategy Group analysis; National Bureau of Statistics of China; People’s Bank of China)
If the property bubble bursts and causes multiple default cases, accompanied by high levels of local government debt, China’s economy will be severely affected. PBOC’s failure to anticipate and to swiftly respond to a cash crunch and seasonal rise in liquidity demand could create a huge financial risk, leading to a disrupted market in the next two to three years, followed by a long period of recovery.
In an upside scenario with enhanced stability of the inter-bank lending market and fewer bad debts, China’s financial sector would be expected to experience healthier growth. By further easing regional property investment constraints, gaining better control of shadow banking, and bolstering consumer spending to support future economic growth, the country’s market-oriented reforms will result in both successful financial restructuring and effective economic rebalancing. To achieve gradual deleveraging, China must also ensure that local governments receive sufficient financing to meet their increasing responsibilities and that they are bound by stricter debt-issuing caps.
As the downturn in China’s property sector continues and financial restructuring reforms are unlikely to take effect immediately, multinational corporations (MNCs) should conduct careful sensitivity analyses to determine their most vulnerable market segments and build contingency plans for a potential financial crisis.
Preparing MNCs for China’s New Normal through 2020
This blog post is the third of a six-part FSG Insight series on China’s economic outlook in the next five to six years and its implications for multinationals’ mid-term strategies. During the next few weeks, I will elaborate on some of the key opportunities and risks that MNCs will need to monitor as they develop their strategic positions in China through 2020. Next week’s update: “Expensive China: Rising Business Costs.”