China slowdown doesn’t foreshadow financial crisis

By Roger Aliaga-Díaz | January 23, 2015 | Last updated on January 23, 2015
3 min read

Many investors are worried about China. The data suggests that, while a slowdown’s is possible, a crisis isn’t in the cards.

Rapid credit growth

Investor concern is understandable. China’s credit boom has fuelled growth (especially following the financial crisis) when export demand slowed from Western economies.

It’s only natural to wonder if China’s overextended.

The issue isn’t so much the fact that loans from the nation’s shadow banking system represent 14% of banking assets, and the overall credit level is close to 216% of GDP. That’s still low compared to many developed and emerging economies.

The problem, rather, is the extremely rapid and less discriminating pace of debt expansion in recent years. The quality of loans extended since 2009 will be tested in an era of lower GDP growth.

But there’s more to consider.

Read: Why China’s headed for growth

Low odds of 1990s-style EM meltdown

China’s debt level is the only thing the country has in common with the most notable emerging- market crises of the 1990s and early 2000s. Measures of China’s banking-system soundness, such as non-performing loan data, are much stronger comparatively. The People’s Bank of China’s (PBoC’s) ability to act as a lender of last resort in foreign currency is also intact, thanks to the bank’s large international reserves and China’s low share of foreign-currency-denominated external debt.

Notably, the PBoC’s lender-of-last-resort role is essentially unlimited for local-currency- denominated debt, which is most of the nation’s debt. This explains the relatively low level of sovereign bond spreads.

Domestic debt not necessarily a sign of overleveraging

China’s average domestic savings rate for the 12 years through 2013 was nearly 50% of GDP. This amounted to a massive flow of wealth, mainly in real estate assets, domestic bank deposits and international securities (foreign equity or bonds). Because a role of the financial system is to transform savings into loans, a high debt level should mirror a high savings rate.

Before the financial crisis, China was mostly exporting its loan capacity: in effect, financing the world’s ability to buy Chinese products. With savings invested in international securities (China’s net foreign asset position increased from 25% of GDP in 2002 to about 56% in 2008), domestic debt remained flat during this period.

But China’s external demand plummeted during the global crisis, and the financial system rerouted savings toward domestic credit to boost domestic demand via investment spending.

Read: Low oil boosts emerging markets

Property market

China’s housing statistics suggest a slowdown of the property market in 2014. Residential construction represents close to 10% of China’s GDP, and there’s potential for indirect impact on related sectors.

The risk of a systemic financial spillover is low. China’s property market is much less leveraged than that of many developed economies: the ratio of mortgage debt to property assets is less than 7%, and Chinese buyers typically need a 30% down payment for a mortgage. Strong government restrictions have also helped to curb property demand for investment purposes.

While a slowdown in China is likely and already priced into the markets, an economic collapse is unlikely.

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Notes: China’s debt ratios calculated as percentage of four-quarter rolling sum of GDP. Some components of public debt as bonds issued by municipal construction companies and local government financing vehicles (LGFVs) are reported as corporate bonds and bank loans to local governments. General government debt includes that of the central government and some state and local debt.

Sources: Vanguard calculations, based on data from CEIC.

by Roger Aliaga-Díaz, Ph.D., a principal and senior economist with the Investment Strategy Group at Vanguard.

Roger Aliaga-Díaz