China: Approaching a Cyclical Reprieve?

All summer, news from China has been grim, pointing towards a growing risk of a debt deflation spiral. Our favourite economic historian, Russell Napier of Orlock Advisors, defines a debt deflation in this way:

“A debt deflation is when falling asset prices spur debtors to repay their debts. The repayment of bank debt, if it creates an aggregate contraction in bank credit, will reduce the money supply. A reduction in the money supply is a liquidity contraction which likely produces a further fall in asset prices. There is thus a very negative feedback loop which sees further loan repayments, further contractions in money supply and further falls in asset prices.”

Escaping this trap will require a debt restructuring plan that balances sufficient loss to avoid moral hazard with the need to avoid excessive stress on the banking system, which would only exacerbate the tendency towards a contraction in bank credit (Figure 1). It also requires growth in consumption, and sustained inflation. None of these things are easy to engineer, though there is now a well-established playbook from developed markets over the last 15 years on exactly how to do it.

Figure 1. New Monthly Loans Have Fallen to 14-year Low

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Source: People’s Bank of China data showing monthly loans in Chinese renminbi, to 31 July 2023, sourced from Bloomberg.

Taking a step back, however, it is worth remembering that the problems that now dominate the headlines regarding China are not new. Since 2011, high-profile international short sellers have been exercised about the debt in the Chinese property sector and the risk to the banks, and those concerns have reared their head time and again over the last decade. Each time the “Minsky Moment” is apparently inevitable, policymakers have engineered a cyclical rebound and the concerns have receded.

Coming back to the current cycle, after months of very modest policy response, policymakers appear to be getting more serious, with a series of announcements in recent days focused on relieving some of the pressure on the property sector, which directly and indirectly accounts for approximately a quarter of China’s GDP. Last week, China’s state-owned Securities Times published a commentary¹ calling for the lifting of policies curbing property purchases outside Tier One cities.

In China, mortgage rules are set locally but are guided by central policy. The intervention is likely to have signalled that the new policy measures set in recent weeks were not trickling down quickly enough.

These changes have taken a multi-pronged approach directed at: (i) easing definitions to allow more borrowers to qualify as first-home buyers, (ii) Lowering downpayment ratios for all borrowers, and (iii) lowering mortgage interest rates for both new and existing mortgages.

This is not yet a bazooka, and by stimulating the property channel again, policymakers are leaning on the old model that has contributed to the build-up in debt, and malinvestment in fixed asset investment. But the experience of the last decade does suggest that if the economy starts to recover some momentum into 2024, the drumbeat of negativity about a systemic collapse will dissipate. Until there is a holistic solution to resolve the debt (particularly for local governments), create inflation, and reorient the economy towards consumption, the problems will be kicked into the long grass, only to emerge again during the next cyclical downturn.

With contributions from Ed Cole, Managing Director of discretionary investments, and co-portfolio manager of equity solutions at Man GLG.

1. www.stcn.com/article/detail/970473.html