Do China’s recent slowdown and credit issues point to a significant hard landing going forward?

In a news article dated June 20, 2013, it was reported that China’s economy seemed to show some signs of a contraction with the latest flash HSBC Purchasing Managers Index (PMI) showing a reading of 48.3, which is quite a significant contraction from the May’s final reading of 49.2. A reading of 50 suggests a neutral level of production activity. According to a survey of 15 economists by Bloomberg News, the median estimate was 49.1 for the month of June, or essentially no change from the May’s final reading. This latest June 2013 preliminary reading highlights a deep concern for many Chinese Politburo members on the issue of how to allocate the amount infrastructure spending, while letting market forces dictate growth in the Chinese economy.

The country’s top leadership, namely Premier Li Keqiang has emphasised on the level of infrastructure spending that the Chinese Government was willing to handle, while at the same time manage long-term growth expectations. However, as indicated in my latest blog article on the potential risks of not dealing with the ‘shadow’ banking system might cause a severe downturn to the Chinese economy going forward. It is because most of the infrastructure spending requires capital funding, and with debt relatively cheaper that issuing equities in terms of cost, firms are likely to look to banks or tap into the debt markets in the form of issuance of the so-called ‘Dim Sum’ bonds, or Chinese Yuan currency denominated fixed income instruments. However, these ‘Dim Sum’ bonds are issued offshore, and with the Chinese economy looking much dire these days, higher yields are warranted for the expected risks of holding Chinese debt, and it could be quite costly for firms, especially the small-and-medium sized enterprises (SMEs) to fulfil their debt obligations.

Based on the June 20 Bloomberg article, it was also mentioned that China’s seven-day repurchase (Repo) rate, a gauge of interbank funding availability, touched approximately 12.0 percent on the same day when the article was published. In a previous blog article when I wrote on the debt situation in China, it was approximately between 7.0 percent to 8.0 percent, and that article was being written as far back as this week. This increase in Repo rates is quite significant as it has to do with funding costs, and leverage levels, which are crucial metrics in terms of measuring solvency, and stress tests on the balance sheets of many Chinese firms being conducted by major credit rating agencies when assigning debt ratings. In fact, one of the state-owned financial institutions, China Everbright Group has recently defaulted on its interbank loan, and to know about this fact that a financial institution, and a bank that defaults on its interbank loan is considered as quite significant which will result in market turbulences if placed in the US financial markets context. I believe that the central banking authority, the People’s Bank of China (PBOC) is closely monitoring the situation, but whether it is able to impose tougher regulations on non-bank financial institutions, including leasing firms, and other unregulated entities thriving under the shroud of the ‘shadow’ banking system remains unclear, given that the PBOC has not officially issue any new rules and regulations that tackle this issue on a more stringent mode.

Many market pundits tend to dismiss the credit issue and the current downturn shown in the economy as part of economic progression, and the issues will eventually be solved using the massive Chinese government intervention, which was known to have vast foreign reserves that can easily contain a credit crisis. However, in my opinion, this is not the right approach of not thinking about the amount of systemic risks that amounts to massive defaults, a prolonged slowdown of the Chinese economy, vast civil unrests occurring in many provinces, engaging in territorial disputes in order to consolidate its hold on resources, etc. These potential risks need to be outlined and emphasised in many investors’ minds. The Chinese Government could not possibly backstop all systemic events, given that it does not even have the full control in dealing with the frequent smog, pollution, and alleged food hygiene issues that resulted in loss of lives for many Chinese people.

The issues do illustrate the severity of the issues, but the Chinese Government will always be in denial of the current economic facts. Some unscrupulous merchants have also been found to use fake invoices for shipments that do not correspond with the Customs Declaration forms. Although China did admit recently that some of its fake invoices might have inflated the official trade figures, but there were no clear solutions, rules or regulations being implemented to guard against future wrongdoing. There are several cases that one can cite of severe mismanagement issues with the Chinese Government, but if there are no concrete actions that are forward looking, and fair for all parties concerned, then it does not create any significant impacts, and possibly increase the amount of scepticism shown by most Chinese people and investors on the actual relative performance of the Chinese economy.

About Hock Meng Tay - Chief Editor, Asia-Pacific Region

Hock Meng Tay, CAIA has written 181 post in this blog.

Chief Editor, Asia-Pacific Region Hock Meng Tay is a CAIA holder and is currently taking CFA qualification. He has over 10 years of experience working as research associate in several investment companies.He is an expert in financial analysis and has published research reports in his current role. He obtained his Masters of Business Administration in Integrated Management and Masters of Arts in Economics while serving his internship in Starsource Inc