The Chinese economy saw stutters and instability at the start of the year as 5%-6% annual growth became the projected new normal. As a result, the possibility of a hard landing, resulting in an economic crisis, has been floated by pundits. For a new report a number of stress tests were run, based on models of increased unlikelihood, on the country’s financial position. The results highlight a need for concern and transformation, as bad loans may double from an unofficial 7% in 2015 to 15% by 2019; however, given the strength of the Chinese economy and its low government debt, even in an extreme scenario there is sufficient capital to stave off a hard landing.
After more than 25 years of rapid growth China has become an upper-middle income nation, as defined by the World Bank, on its way to advanced economy status. For the majority, its recent growth investment has taken the lead. Such investments led to the rise of mega cities and supported the manufacturing capacity that produce the common “made in China” tag known in the West. Since the 1980s the economy has been growing rapidly; its GDP has risen 25-fold and more than 600 million people have moved out of poverty. The middle-class now stands at more than 116 million middle and affluent households (with annual disposable income of at least $21,000 per year) compared with just two million such households in 2000.
In recent years, China’s investment led model is highlighted to be unsustainable in the long term, and subsequently much has been said about the need to move to a consumption led economy. Transforming the economy is no easy task, however, and, as highlighted in the headlines recently, corporate debt in the country is soaring, China’s foreign reserves fell by $500 billion, and the stock market dropped by nearly 50% at the start of the year. A new report by McKinsey & Company, titled ‘China’s Choice: Capturing the $5 trillion Productivity Opportunity’, considers the current situation in the country in terms of whether a ‘hard landing’ is on the cards.
Investment pays off
The firm’s analysis suggests that the investment led model is becoming unsustainable, as more and more investment is required to generate improvements to GDP. It now takes 60% more fixed capital investment to produce one unit of GDP than was needed between 1990 and 2010. Factors affecting the market include weak global demand, overcapacity, and the continuing presence of unproductive companies.
The focus on investment led growth has, according to the consultancy, resulted in a relatively lopsided economic situation. Financial institutions have been providing the majority of capital to companies, and they account for more than 80% of total financial assets in China. The institutions have benefitted from a net interest margin of around 3%(profit earned through the difference between deposit and lending rate) over the past decade – with more than 80% of the economic profit generated in China (a measure that takes into account the cost of capital) – comes from the financial sector; which is considerably higher than in the US, where R&D manufacturing leads the way, followed by non-financial services.
While outstanding credit growth rates have continued unabated through 2015 into 2016, questions about the long term viability of the strategy – as well as the potential negative effects, were analysed by McKinsey. The firm ran a number of stress tests, using different possible scenarios, which looked at the risks to bank assets, by assessing the quality of bank lending portfolios, and banks’ exposure to the shadow-banking sector. In addition, the firm looked at risks on the liabilities and equities side: the loss of deposits and the inability to meet capital requirements because of the effect of falling profits.
According to the results from the various scenarios, risks of a hard landing – whereby there is a credit crunch or economic crisis – remain relatively unlikely. The trend however, on the basis of the status quo, is set to see risks increase for every year in which there is inaction. For instance, since 2010 the debt load of 2,300 public companies in the country has more than doubled, even as revenue and margins have contracted for many companies. As a result, more than 30% of companies in the firm’s sample had EBITDA multiples of seven or higher in 2015, up from 20% of companies in 2010. A multiple of seven is generally regarded as a sign of heightened risk of insolvency. In addition, the firm performed a “bottom-up” analysis of company solvency measures – finding that 7% of bank loans could be classified as nonperforming in 2015, compared with the official estimate of 1.7%, and this could lead to loan losses of 350 billion on banks’ current loan portfolios, while the shadow banking risks adds around $250 billion. The analysis also suggests that the current economic conditions are likely to see the poorly performing loan portfolio increase significantly over the coming years to hit 15% of total loans by 2019 – at around $1.8 trillion.
The cost to recapitalise banks in 2019, were the investment led path to continue and were there to be a significant crisis, would require around $1.3 trillion, equivalent to 12% of current GDP. The Chinese economy is relatively robust, however. Chinese government GDP to debt ratio stands at around 50%, raising $1.5 trillion to cover bank loses in the firm’s most extreme scenario would see debt increased to 65% of GDP, well below that of the US and Germany. In addition, the country holds around $3.2 trillion in foreign reserves, and swathes of other assets worth well in excess of the potential hit. According to the consultancy firm, however, while a hard landing is not on the cards, transforming the economy now to a more sustainable model staves off increases in risks.
A previous analysis by McKinsey on China found that leaders in the country are struggling with the inefficiencies of (complex) corporate governance structures, while another study, by Strategy&, highlighted that China is emerging as the globe's hotspot for innovation outsourcing.