Five reasons to worry about China

Chinese credit conditions make us nervous because:

1. Growth and demand are coming from a leveraging up of the credit system, not from income growth as they did before.

2. Credit creation is increasing by bypassing the formal credit system.

3. Debt levels are low by developed world standards, but extremely high relative to economies in similar stages of development.

4. There is preliminary evidence the Chinese credit cycle may be turning. The availability of capital is now being restricted in part by movements by Chinese authorities to regulate more of the sprawling system, and in part by the drying up of foreign capital that had been stimulative.

5. China accounts for about 50% of all global credit creation, 26% of the world’s nominal growth and 31% of its real growth, so how Chinese credit growth plays out will be a large determinant in how the global economy plays out.

In summary, the Chinese economy is more dependent than ever on the booming credit cycle at the same time that global and domestic credit conditions have become less manageable and likely more volatile. Turns in credit cycles are dangerous and how this one is navigated will be one of the major drivers of both the Chinese and global economies. We may already be seeing the beginning of the turn and in response
to the broadening of domestic tightening policy measures and worsening global credit conditions, quarterly credit growth fell significantly in the third quarter, to around 13% (annualized) from growth rates close to 40% in 2009 and 2010.

Over the past few years, the expansion in credit far exceeded the expansion in growth, suggesting that each marginal unit of growth was more and more dependent on expanding credit. In other words, the efficiency of credit has fallen substantially, consistent with the picture of uneconomic investment and overcapacity.

Looking forward, continued credit growth at the pace we’ve seen since the crisis would be unsustainable.
But without this underlying support, especially given the context of slowing global growth, there is a significant risk of a meaningful slowdown in Chinese growth. The slowdown in credit growth so far has only been moderate, but managing an orderly slowdown in credit growth going forward will likely be a
difficult process.

As mentioned above, in recent months, there has been some flattening off in the level of credit relative to
GDP, but the short story remains that going forward, reliance on continued credit creation is stronger than ever. Debt levels rose by close to 60% of GDP since 2008 and are at extremes relative to history.

Going forward, existing debts will need to be serviced through some combination of income and more credit. Given how fast credit was pumped out over the past three years, there are risks that there will be heavy reliance on the latter (e.g., investments may not yet be generating income).

We have already seen marginal borrowers getting squeezed (e.g., Wenzhou lenders and small property
developers, among others) and loan extensions/restructurings/subsidies are helping to keep many infrastructure-backed loans viable.

If access to credit becomes more difficult, these borrowers will be in a tough spot.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla