What Is Behind China’s Deleveraging Policy

In starkly dramatic terms, the Bank of China’s Governor, Zhou Xiaochuan, raised the specter that the country could face a “Minsky Moment “. Named after the late economist, Hyman Minsky, the term refers to a sudden collapse of asset prices after a long period of growth, sparked by debt or currency pressures. (Many use this term to characterize the financial crisis of 2008, culminating in the collapse of Lehman Bros.)

The Governor was referring to the accelerating levels of corporate and household debt even during a time of rapid economic growth. We are all familiar with China’s extraordinary growth  over  nearly two decades. No doubt this performance provides a lot of optimism on the part of the private sector to take on increasing debt.

Are there beginning signs of an impending Minsky Moment in China?  Lets look at the main issues facing the government:

• Private debt levels have risen sharply. According to IMF estimates Chinese bank assets are 310% of GDP in 2017, compared to 240% in 2012; non-financial debt is forecast to hit 300% of GDP by 2022, up from 242 % in 2016;

• Public debt levels continue to grow.  Government debt equals 46% of GDP ( Figure 1). Granted in a command economy, public debt can be eliminated with a stroke of a pen, nonetheless these levels put pressure on the government to curtail  the growth in public debt.

Figure 1 Public Debt to GDP

                            

• Commodity prices are falling. There has been a dramatic drop in the price of  key commodities, such nickel, copper and basic agricultural products ( Figure 2). Some of these drops are traced to over supply conditions and others to weakening demand. Either way, falling commodity prices are an early warning sign of  economic weakness. The growing weakness places greater emphasis on the need to curtail debt to prevent a financial crisis.

Figure 2 Commodity Price Index

                                     

• Credit conditions are tightening.  A sure sign of financial stress is the rapid rise in the interbank lending  rate  for Hong  Kong banks (HIBOR). The Chinese banks are concerned about lending to each other overnight and have pushed up the HIBOR from 0.4% to over 1.0% ( Figure 3)

Figure 3 Credit Conditions

                  

• Long term bond yields drop.  Another sign of concern in the financial markets is the dual impact of falling long bond yields along with a sharp decline in stock prices. When the 10yr bond yield jumped to 4%, the PBOC pumped in liquidity to nudge the rate down. Nonetheless, pressures are building up in the bond market in response to concerns about rising debt levels.

• Wealth Management Products (WMPs) are declining. WMPs are offered by the ‘shadow banks’ because they are a close substitute for bank deposits. They are purchased by wealthy investors seeking higher returns than those offered by commercial banks. The steady decline in outstanding WMPs is a further sign of tightening credit conditions in China  (Figure 4). Although shadow banking is not very large , the business is inherently riskier than conventional banking. A failure in this sector could trigger wider loan losses extending into commercial bank lending.                                                                                                                                                                                                                  

Figure 4 WMPs

                         

In sum, although household wealth has risen significantly, household debt has risen even faster. This has raised alarm bells in the government and with overseas investors. In addition, a similar pattern is occurring at the corporate level. So, deleveraging will be necessary to bring the growth of liabilities more in line with that of assets. The process has just got started and it is a long way from completion.