LAST month the People’s Bank of China (PBoC) released data on the stock of credit in the economy. As of the end of 2014, the stock of total social financing (TSF) was RMB123 trillion, 193% of GDP. This shows that credit growth is still outpacing output by 6 percentage points. The question on many analysts’ mind is whether China has reached a global maximum in credit to GDP, or if it will continue to rise over the next several years.
It is helpful to consider the numerator and the denominator, though intrinsically related, separately. While forecasting the denominator – GDP growth – is outside the scope of this post, there is ample reason to believe it will be lower – perhaps close 7% for 2015, down from 7.4% in 2014. Therefore, in order to maintain a constant credit-to-GDP ratio, credit growth would need to decelerate by more than 6 percentage points. In the second half of 2014, credit growth did slow considerably: nearly all of the increase in credit-to-GDP occurred in the first half of 2014. However, credit growth is often stronger in the first half of the year than the second half, due in part to an arcane system of quantity-based credit rationing. Therefore, the slow-down in the last two quarters of 2014 is not abnormal, and could account for some of the seasonality observed in the output data (see exhibit 4). TSF growth continued to slow in January, though subject to the usual vagaries of lunar new year distortions.
It seems unlikely, however, that Chinese authorities will tighten credit further. In fact, in the past three months the PBoC has twice cut rates and further easing is likely in the coming months. Indeed, there are several headwinds facing the Chinese economy. Property investment growth is down by nearly a half since 2013, year-over-year housing price growth is approximately -5%, and FDI investment will like contract after a seasonally strong January (due to an early 2014 lunar new year -> low base effect). Furthermore, disinflation or outright deflation is showing persistence in many sectors, as we showed in a previous post. Externally, with the exception of the US, demand remains tepid: exports growth is negative, and global monetary easing is leading to weak currencies versus the US dollar, which the RMB is still effectively managed against.
Therefore, barring an upside surprise in global growth or excessive austerity in China – both of which we find unlikely – we will likely see to a further increase in credit relative to GDP in 2015, though at a slower rate (1st derivative positive, 2nd derivative negative). A continued expansion, however worrying, may be more prudent in the current environment than an abrupt tightening – though there is a question of credit demand (see exhibit 7). Indeed, given the very low levels of external debt, strong household balance sheets, and relatively well-capitalized banking system, the scope for a financial hard landing appears limited in the medium term. That said, as China begins reduce its overall economic velocity, there are several things to look for in determining whether this multiyear process will be “beautiful” deleveraging, or one of the homelier variety:
1. Composition. As much as absolute level, the types of credit delivered to the economy is important. In the past 12 months, authorities have moved to arrest the flourishing of off-balance sheet financing and promote greater use the capital markets (see exhibit 2). In 2014, trust and entrusted loans made up just 18% of the net increase in TSF compared with 25% in 2013. Bond and equity issuance on the other hand represented 17% of net TSF in 2014, up from just 12% in 2013. This is especially important for local governments as authorities attempt to develop the domestic municipal bond market.
2. Disposition. Relatedly, if the authorities are sufficiently worried about the health of the economy and decide to ease monetary conditions further (as is widely expected), how they choose to do so is very important. Policymakers in China should continue to use price-based measure such as interest rate cuts and reserve ratios to encourage greater expansion of credit, as opposed to the quantity-based easing program after the financial crisis. This should enable banks to discriminate appropriately on price and lend to profitable firms. Indeed, as with the exchange rate, the authorities have taken advantage of the weak rate environment to raise the deposit rate ceiling to 30% from 20% above the benchmark. While the maximum deposit rate is still below what it would be under full liberalization, further liberalization of deposit rates would likely raise funding costs for banks and yield more productive investments.
3. Non-performing loans. After the financial crisis, the authorities flooded the economy with credit via the state banks, funding vast quantities of unproductive investments. However banks’ non-performing loan ratios remain low. In a cursory analysis of historical episodes of extraordinary increases in credit-to-GDP ratios, we find that they are often followed an increase in non-performing loans (see exhibits 5 and 6). Although NPL’s have indeed risen since the credit boom, until recently they were outstripped the rise in gross credit. Allowing unproductive and uncompetitive firms to fail and make room for more productive (mostly private) firms to replace is necessary for deleveraging to be “beautiful”. We expect to see more medium profile bankruptcies in 2015 and a continued, though controllable, rise in non-performing loan ratios.
Exhibit 1: Total social financing vs. GDP
Source: PBoC, NBS
Exhibit 2: Estimated stock of total social financing by category
Note: total loans = rmb loans + fx loans; total off-balance sheet financing = entrusted loans + trust loans + bankers acceptances; total capital market financing = bond issuance + equity issuance
Exhibit 3: Growth of total social financing, year-over-year
Exhibit 4: Credit and output growth in the first half of the year vs. the second half, RMB billion
Source: PBoC, NBS
Exhibit 5: Distribution of 5-year increases in credit/GDP in 20 countries, 1980-2013
Source: BIS, IMF, author’s calculations
Exhibit 6: Peak 5-year credit growth episodes of greater than 60% of GDP and subsequent 3-year net non-performing loan ratio increase, 1996-2013
Source: BIS, IMF, author’s calculations
Exhibit 7: Banker’s survey of loan demand climate
Note: (贷款总体需求指数) This is a diffusion index of loan managers, with respondents indicating “1” for good/growth expectations, “0.5” for no change/flat, or “0” for contracting growth. For the latest survey and details thereof, see HERE.