On September 17th, 2014, the People’s Bank of China (PBoC) unleashed a mini-stimulus package aiming to replenish the big 5 Chinese banks balance sheets with RMB 500 billion ($81.4 billion, or $16.3 billion each). Observers also expect a strong easing signal from PBoC such as a cut in interest rate. Why? Because this would support the banks and thus the economy.

The growth target would be indeed easier to achieve and net borrowers (although already insolvent in some cases) would still be able to keep borrowing at a low interest rate, effectively rolling over their non-performing loans (NPLs). In addition, despite the government pledge of maintaining the GDP at around 7.5% and conducting structural reforms, economic growth keeps weakening. Premier Li Keqiang has often reiterated that China is not going to roll-out stimulus to deal with short term fluctuations and instead keep China in the difficult but necessary path of structural reforms.

However, the latest figures show that Chinese economy is declining faster than previously thought. On a year-on-year basis, Foreign Direct Investment (FDI) growth has been negative since Q2 2014. The Manufacturing Purchasing Manufacturing (PMI) has not really picked up and the real estate sector is under heavy pressure. Given its significant share of the economy (at least 15-20% of GDP), the real estate sector is a good proxy for manufacturing activity, commodity sector and overall confidence in China.

These recent developments suggest that China is at a crossroad: keep on reforms with a looming hard landing or deal with short/medium-term downward pressure by using the old and exhausted tool of credit expansion? The PBoC’s action suggests that the government tries to find way in-between. In other words the government can neither afford a hard landing nor can it allow the growth to crash. In the meantime it has to implement reforms to find a sustainable path for growth in the future…

So far there are no big stimulus in pipelines, as these are too painful for the economy over the long run and don’t address the underlying weaknesses of China’s economic model. Having said that, one can still wonder what is the reason for the decision by the PBoC to inject that much liquidity? Here is a summary of analysts’ opinion on this issue:

  • Reduce borrowing cost
  • Easier to rollover existing debt
  • Possible cash shortage in the coming days due to National holidays
  • Help to achieve ± 7.5% target

Although these considerations might be true, one of the main reason must lie in the deterioration of assets that Chinese banks hold. Indeed, since the growth and credit are rapidly slowing down, there is no doubt that NPLs are rising fast in China. If not for the rise of NPLs, such a large amount of liquidity would not have been necessary and could have been met using standard Open Market Operations.

20140214_chinanpl_0

Zerohedge 06/2014

This chart illustrates the NPLs (in billion RMB) amount for every quarters from Q4 2008 to Q4 2013 (which unfortunately does not show the NPLs evolution through 2014). However, given the array of poor economic data since the beginning of the year, it is obvious that NPLs keep rising. To some extend this might be regarded as a good news: indeed, one might argue that because China is rebalancing, therefore the rise of NPLs is a normal outcome. Short term pain is acceptable for long term gain.

Back to the PBoC action, the liquidity injection only targeted support for the big 5 Chinese banks and their ability to absorb the losses. A quick look at real estate and mining related companies shows that the debt/equity ratio can reach up to 200% which is considerably high. Under such circumstances it is fanciful to think that Chinese companies are deleveraging. Indeed, deleveraging means that either that the borrower pays back principal + interest from the cash flow it can generate or the borrower default.

Simply put, if growth is weakening fast, borrowers are not able to generate enough cash flow to pay back their debt. In this case, if borrowers don’t default, this means that they are borrowing more to rollover debt. The trick is that as long as borrowers can borrow to avoid bankruptcy, they will do so. This implies that as long as the government steps in and bails out “zombie companies”, borrowers would still have incentives to borrow regardless of the interest rate or the expected return of the project.

However, after few quarters of ultra easing monetary policy following the 2008 financial crisis, the PBoC is now trying to rein credit significantly in order to avoid a banking crisis. It went from easing stance during 2008-2010 to mostly neutral/tight since then. Recall that the expansion of credit in China Post-2008 has simply been off the chart. Some industries are now hit hard, especially commodities related companies.

A few days ago, iron ore dropped to its 2009’s low to around $80/metric ton. Such low price puts heavy pressure on iron ore producing and trading companies. In China, companies are simply shutting down when they can’t borrow more money and their production cost exceeds the price of the commodity. However, one must also consider that injecting capital now might just have a reverse effect of what the government expect: moral hazard is still pervasive in China.

Indeed, Chinese banks remain confident: in case of shock, they expect the Chinese government to bail them out. Why? Simply because the banks belong to the State, so under this logic, the government has to bailout itself! This is not a proper way to force the banks to be responsible. Here we have also to notice that net borrowers are often state (or state related) entities. Therefore, Chinese banks have to and are willing to lend to them due to the implicit guarantee and the close relationship the two sides cherish.

Today, the Chinese government’s conundrum is to navigate between sustaining economic growth while shifting toward a more sustainable model. After 30 years of rapid economic growth, 10 years of successful international rise and 5 years of unsustainable credit expansion, China is now faced with an unstable and dangerous situation from which few countries managed to break out.

Last but not least, one could also wonder whether the PBoC decision to inject liquidity is linked to the Fed Quantitative Easing tapering and the ECB potential easing?

About Steve Nguyen

Analyst based in China for 4 years, with significant analytical skills in Macroeconomics, Financial Markets and the Chinese economy.