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Fast credit may be seismic faultline for China's economy
IN his 2012 bestseller "Breakout Nations", Ruchir Sharma punctured a lot of the euphoria surrounding emerging markets. Many of these countries' apparently dazzling growth performances during the decade leading up to the 2008 global financial crisis were fuelled not so much by impressive transformations, but simply by "a worldwide flood of easy money."
Historically, growth has not proved easy to sustain for more than three decades - China has been more the exception than the rule.
But now, Mr Sharma, who is managing director and head of Emerging Markets and Global Macro at Morgan Stanley Investment Management, is predicting that China, too, is on the cusp of what could be a prolonged economic slowdown.
The reason: an explosion of credit and debt since 2009.
China's slowdown is a hugely important event, which poses risks not only to China itself, but also to other emerging economies and global growth.
Speaking at Morgan Stanley's Global Ideas Conference last week, Mr Sharma said that history shows credit growth is a powerful predictor of financial crises. The evidence for this goes way back to the Tulipmania of 17th century Holland, during which the sellers of tulip bulbs provided credit to the buyers. It was also true of the South Sea bubble of the 18th century, where massive credit fuelled an orgy of speculation before the bubble burst; and the crash of 1929 on Wall Street which was preceded by a huge credit-driven stock market boom. Outsized credit growth was also a feature of more recent crises like the Mexican "tequila" crisis of 1994, the Asian financial crisis of 1997 and the global financial crisis of 2008.
What really matters, according to Mr Sharma, is not the amount of credit, but its pace of growth. "Credit growth can be healthy, but not if it is too fast," he said.
Research shows that if credit as a proportion of GDP rises by 14 percentage points over five years, that is one standard deviation above the mean. If it rises by 28 percentage points, that is two standard deviations away. And if it grows by 42 percentage points, that is a three standard deviation event.
The faster credit grows, the more economic growth tends to decline subsequently - usually because a lot of credit flows to economically dubious projects.
"It's easy to party, but hard to clean up," said Mr Sharma. Citing his studies of 30 of the most explosive credit binges in history, he pointed out that when credit to GDP rose by at least 42 percentage points over five years, an economic slowdown followed in every single case. In 70 per cent of cases, an economic crisis occurred.
The most prominent recent example was Japan which enjoyed a massive increase in credit in the 1980s, after which economic growth collapsed from 5.2 per cent in 1990 to 1.4 per cent five years later.
Escalating margin debt
In China, the credit to GDP ratio (which has been accompanied by a massive increase in debt) has soared from 140 per cent of GDP in 2010 to just over 200 per cent at present. The ratio has risen by more than 65 percentage points. This is well beyond three standard deviations above the norm. Moreover, new debt in China has not been generating much growth. "Before 2007, one dollar of debt generated one dollar of GDP growth. But by 2013, it took US$4 of debt to generate the same one dollar of GDP growth," Mr Sharma said.
If historical evidence is any guide, after such a binge in credit and debt, China's economy will slow down. Noting that in the five years to 2015, China's growth averaged 8.5 per cent a year, Mr Sharma estimates that it will slow to 4-5 per cent by 2018. It is already running at barely above 5 per cent - and the risks are on the downside.
Of course, in many areas, China's fundamentals are formidable. Notably, it still enjoys a current account surplus and has foreign exchange reserves of just under US$4 trillion - the biggest in the world. These positives "can prevent a run on the currency", says Mr Sharma. "But they cannot prevent a growth slowdown."
But China's stock market has been on a tear. Since the start of 2015, the Shanghai Composite Index has risen 44 per cent while the Shenzhen Composite has soared 96 per cent in US dollar terms. How does this square with the slowing economy?
"China's equity market and economy have little relationship with each other," said Mr Sharma. "The equity market is being propped up mainly to deal with the debt crisis. The government wants companies to raise equity because the credit markets are clogged."
He urged caution on China's equity market. "Margin debt is higher now than at any time in the country's recent history - a classic sign of a bubble," he said. "Five years ago, there was no margin debt."
As always, there are contrarian views on China. Justin Lin, former chief economist of the World Bank and currently director of the China Centre for Economic Research at Beijing University, believes that China's slowdown is largely cyclical and externally driven (and as such, temporary). Moreover, he thinks that as a middle income country, China can continue to invest 50 per cent of its GDP to drive its growth - provided the investments are productive, and he believes there is a lot of scope for such investments. China's government is also trying to rekindle growth through monetary stimulus.
But Mr Sharma is not as sanguine. "For me, what has really changed in the last five years is the debt," he pointed out in an interview with BT. "Up to 2008, China's boom was not financed much by debt. Debt to investment ratios were quite stable. But after 2008, the entire character of this changed dramatically. That is the faultline."
Something similar happened in Japan, Korea and Taiwan in the 1980s and 1990s and they all went through prolonged downturns.
It is tempting to suggest that China is different, he says. "People say all the gloom forecasts on China have been wrong for the last 30 years. So why should they be right now? My point is something has changed in the last five years, and that is the debt profile. And that change has been dramatic."
Moreover, China's investments have become less and less productive since 2010. "Look at the incremental capital output ratio," says Mr Sharma, referring to the measure of how many units of capital it takes to produce one unit of output. "That's been rising sharply in China."
Fallout from slowdown
The main impact of China's slowdown on other emerging markets will be to lower their growth rates as well, according to Mr Sharma. "It's already playing out," he says. "Typically a one percentage point slowdown in China reduces emerging market growth rates by 70 to 80 basis points. In 2010, when China's economy last grew at close to 10 per cent, the emerging market growth rate was about 6 per cent. Today, China's growth has gone down to around 5 per cent and emerging market growth is 3 to 4 per cent. You can explain almost the entire slowdown in emerging markets based on China's slowdown."
Another major impact of the slowdown in China could be felt in commodity prices.
Commodities "will likely remain in a long slumber", he said. History supports this view, he claimed.
"Over 200 years, the return in inflation-adjusted terms on commodities has been zero. The historical pattern is typically commodity prices go up for one decade and go down for two decades."
This is true of oil as well. "A lot of people think the oil price has collapsed. All that has happened is that it has come down to near its long-term average, which is around US$55 to US$60."
From the 1990s, a huge jump in demand from China pushed up commodity prices, including that of oil. But with China's voracious appetite for commodities on the wane, prices will soften. "The next few years will be a long winter for commodity prices," said Mr Sharma.
For all his gloom, Mr Sharma is relatively bullish on South-east Asia, particularly the Philippines. "You had an economic boom in the Philippines, with growth of 6-7 per cent in the last three years, but none of the credit metrics look extended. Loan to deposit ratios are still low and credit growth has not exceeded GDP growth by a large margin."
Indonesia too "doesn't seem to have too many excesses", he said, adding that the current account deficit seems to have stabilised, the rupiah has adjusted and credit is not over-extended. Indonesia will be hurt by some of the commodity price declines, but this should be offset by the decline in oil prices, as Indonesia is a net oil importer. In oil exporting Malaysia, however, the adjustment might be greater.
"Overall, on a relative basis, South-east Asia still seems in decent shape," he says.
"But if China has another downleg in growth - say its growth falls to 3 to 4 per cent - all bets are off. The entire emerging world from Korea to Brazil is going to get badly knocked," Mr Sharma cautions.
"In the past, global recessions were made in the United States. The next global recession will be made in China. When it happens, the whole emerging world will suffer. For commodity producing countries in particular, that's a major risk."
"It probably won't happen in the near term," he added. "But the slide is on."