Fitch Downgrades China: Miracle or Mirage?

China’s sovereign credit rating was cut by Fitch Ratings yesterday. Analysts at Fitch called out China’s growing debt burden on local governments. Fitch estimates that total credit in China’s economy now exceeds 198% of GDP, much of this is carried by government-sponsored entities and local governments. In addition, the report highlighted the growing problem of shadow banking in China, where, it seems, scant few actually know how it works, let alone how big it is. As highlighted in a Financial Times article, it appears that trusts are at the heart of China’s shadow banking.

According to former Chinese finance minister Xiang Huaicheng, local governments owe at least $3.2 trillion — almost double the official figures.

For those following Michael Pettis, this should come as no surprise. Last year at the CFA Institute Annual Conference in Chicago, he laid out the case for a slowing China. Front and center for Pettis was the gross misallocation of capital across China. “Early in the life cycle of a government it is relatively easy to identify worthwhile and valuable investment projects. However, those needs are met relatively quickly. Then it become very difficult to determine which projects are worthwhile.”

While many contend that China needs to move from an investment-driven economy (with high savings rates) to a consumption-driven economy (with low savings rates), they falsely view this phenomenon as the result of cultural choices or habits. In reality, high rates of investment are created by government policy geared toward investment, employment, below-market interest rates, loose monetary policy, increasing debt, and often currency market intervention. As highlighted by my colleague Rebecca Fender, CFA, China didn’t grow quickly despite low consumption, but because of it. China has been systematically transferring income from households to investment via:

• an undervalued currency, equivalent to a consumption tax on imports;
• low-wage growth versus productivity, a gap that has widened greatly in the last decade (the difference between these is like a tax on consumers); and
• financial repression (i.e., extremely low interest rates), which taxes savers and subsidizes borrowers.

One thing that remains unclear is the relationship between the trusts that are funding loans and the parent organizations (i.e., banks). It is thought that many of these trusts are created by wealth management arms of banks in China. If the underlying investors in the trusts are assuming all of the risk, then the risk of financial contagion is mitigated. If the banks stand behind these loans, however, then banks balance sheets will go haywire when loans start to sour.

Recently, signs of trouble have begun to emerge. According to economist Larry Lang, 10 out of 16 listed Chinese banks have stock prices that are trading below their book value, suggesting that the market smells trouble. Much of the cash from local government loans have also wound up in the pockets of corrupt government officials — leaving the government with the liability and private citizens with the assets (often in real estate) — thereby exacerbating the problem.

If it can’t go on forever, it won’t. Change is coming to China. The question is: Will the transition be smooth or rough?

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.