China’s systemic risk

Is the China stock market rout more a sign of a ‘black vulture’ event rather than a ‘red swan’ one?

For Maarten-Jan Bakkum at NN Investment Partners (NN IP), it is.

Forget about trying to cheer us up with an upbeat prognosis based on newly unearthed facts and figures, like exchange-traded fund firm Source recently did, Bakkum – who is NN IP’s sernior strategist in emerging markets equities – says it is becoming increasingly recognised that there is a real risk of a Chinese credit crisis.

From a note out this morning, he says that competing interest got in the way of rebalancing the economy so there would be less dependence on investment and export growth, and greater importance for consumer spending.

“The sectors with the largest excess capacity were rarely addressed, as local governments had major economic interests in those sectors. Overcapacity became even more significant in industries like steel and aluminum, and in parts of the housing market as well. It gradually became clear that the economy only became more dependent on credit. So the most urgent measure – reducing the debt level in the economy – came to nothing.”

Since a stimulus package in 2008 the debt ratio has increased by 85 percentage points, which Bakkum says is unprecedented anywhere in the world and leads to a “significant risk of a credit crunch”.

Confidence in the Chinese government is declining significantly and with €700 billion of outflows in recent months, authorities have “clearly been overtaken by developments”.

Bakkum says this makes an economic recovery increasingly unlikely, which in turn leads to more capital flight and makes further rate cuts necessary. The renminbi needs to depreciate further in this process, he says, but this would have undesirable effects on the financial system, as companies have accumulated a foreign debt of roughly $3 trillion (€2.65 trillion) dollars during the years of renminbi appreciation.

Even Source, in its warmer appraisal of things, noted that with total debt equal to 230% of GDP, this could limit growth and present a systemic risk.

In conclusion, Bakkum says: “For a long time, investors considered a sharp slowdown in growth to be the biggest risk in China. In recent months, the focus has slowly shifted to a systemic crisis. This creates great uncertainty in the financial markets. And it’s not just affecting emerging markets. Finally, the realisation begins to dawn that there is a real risk of a Chinese credit crisis.”

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