Opinion: Two reasons not to fear China’s deleveraging campaign
Short term pain from deleveraging shouldn’t be misread as a wider economic malaise
With receding political risks in Europe and no further escalation of tensions (so far) on the Korean Peninsula, global investors are on the hunt for the next pressure point in the global economy. While Trump has gathered renewed attention due to a few “missteps”, it is China that tops the investor concern list according to recent surveys.
This, in our view, is ironic, as far as the macro picture is concerned.
Economically, China has just had its best start to the year, in nominal growth, in more than five years. Even though the momentum has cooled somewhat in April, the absolute levels of data are still pointing to solid growth so far in the second quarter.
Furthermore, the yuan’s exchange rate and capital flows – a key area of investor concern in recent years – have been steady as a rock since the start of 2017. This has, in fact, been the calmest few months for China’s external account since the exchange rate regime change in mid-2015.
So what is it that investors are worried about then?
In contrast to fears about the Chinese economy falling off a cliff in the second half of 2015, and again in early 2016, investors are currently worried about the official campaign on deleveraging, which has tightened market liquidity and slowed credit growth.
In financial markets, this has triggered a broad-based sell-off across equities, bonds and commodities, as risk sentiment deteriorated and positions are unwound by shadow banking entities. Onshore equities, for example, have given back their entire gains since the start of the year, with the Shanghai and Shenzhen bourses once again trailing other regional markets in year-to-date performance.
Besides the market impact, there are also nascent signs that the deleveraging campaign is causing a negative spillover to the real economy. Depleting market liquidity has driven up corporate bond yields, forcing some borrowers to postpone bond issuance. At the epicentre of the regulatory tightening, shadow banking credit has dried up, with entrust loans showing their first monthly decrease since at least 2007. Finally, rising market interest rates are starting to creep into higher funding costs for the real economy by lifting interest rates on bank loans. All of these might have contributed to the slowing economy as reflected in the latest data.
Hence, does this mean that investor concerns about the current tightening are justified? Here, we are not as concerned, for two reasons.
First, as important as deleveraging is for curbing long-run financial risks, it has always been our view that the authorities will proceed with caution to minimise shocks to the near-term economy. After all, maintaining a stable macro environment ahead of the political reshuffle remains a priority for Beijing.
Plus, the official growth target for this year is only 6.5 per cent, with the market consensus slightly higher at 6.6 per cent. Some slowdown from the first quarter’s 6.9 per cent growth is therefore expected in the upcoming quarters. In fact, a policy-engineered slowdown, as we currently have, is more preferred than those caused by uncontrollable shocks.
Second, there exists a fundamental contradiction in “what investors want” and “what they fear” with respect to their China expectations. As mentioned before, the current concern about China centres on deleveraging and regulatory tightening. But are those actions (i.e. deleveraging and credit control) not precisely what global investors have always encouraged China to do to reduce systemic financial risks?
Such an apparent contradiction is not the first time it has happened to China. During the peak of the yuan’s exchange rate volatility in 2015, the market was critical of whatever Beijing did: loosening its grip on the yuan – letting it slide with the market – was seen as China competitively devaluing its currency; tightening its control to hold the exchange rate steady was interpreted as China manipulating the currency. Basically, there was nothing that Beijing could do to please the market.
The bottom line is China is actively dealing with a structural and chronical imbalance in the economy, and such an action is bound to have some near-term costs. Excessively focusing on these near-term costs, without the long-run benefits, could risk losing the big picture for some investors.
For Beijing, we expect the authorities to proceed the campaign at their own pace. Unless the market jitters turn into outright panics, with global spillovers, the broad direction of the operation is unlikely to change. With the still solid growth backdrop, Beijing can afford to tolerate some of the collateral damage from deleveraging. But the key is to avoid overtightening and manage the degree of spillovers to the economy and financial markets.
Aidan Yao is senior emerging Asia economist at AXA Investment Managers