China's economy is growing more slowly than many observers had expected. Gross domestic product (GDP), the broadest measure of economic activity, grew by 7.5% in the second quarter, down from 7.7% in the first quarter of 2013. GDP growth in China could slow even further, as 7.5% growth is being anticipated for all of 2013 — which would be the country's lowest annual growth rate since 1990.1
This slowdown has generated concern among economists and investors that China's robustly growing economy, which had been posting double-digit growth rates under the former Premier Wen Jiabao, is headed for a "hard landing" as China faces pressure from higher production costs, slowing infrastructure investment and growing financial sector stress.
If a hard landing were to occur, it could have a negative impact within China on real estate prices and could lead to a potential surge of nonperforming loans in its banking sector. At the same time, a slowdown in the Chinese economy could negatively affect the rest of the world through exports, commodity prices and financial markets.
The Chinese economy is at a crossroad
The previous policies of the Wen administration, which included a $586 billion stimulus program in 2009, were focused on supporting further economic growth and expansion at the expense of adding to economic imbalances, the consequences of which are being felt today.
But as the economy slows, the new government under Premier Li Keqiang has an opportunity to pause and take stock of what kind of economic policies are necessary to promote a more balanced and sustainable approach to long-term economic growth. Policies that aim to reduce Chinese reliance on exports and foreign investment by promoting growth through energy-efficient technology and greater consumer spending, for example, could be key factors in such future growth prospects. However, in the near term such policies could result in slower growth, reducing the likelihood that China will begin producing double-digit growth rates again anytime soon.
Implication of new government priorities for off-balance sheet and nonbank lending
As China's new government seeks to create a more market-oriented economy focused on sustainable long-term growth through structural reforms, one casualty may be the booming business of nontraditional credit, also known as "shadow banking." Until recently, this type of off-balance sheet intermediation provided lenders and borrowers some flexibility in China's otherwise strict official lending environment.
Such lending, broadly known as "total social financing," averaged 1.692 trillion yuan ($273 billion) in the first six months of 2013, an increase of 280% from 679 billion yuan ($97 billion) generated during the first six months of 2008.2,5 Moody's estimates that core shadow banking products totaled 21 trillion yuan at the end of 2012, representing 39% of China's GDP last year.3
This scope of activity has raised concerns about the amount of leverage and systemic risk in China's banking system. Local governments, for example, set up more than 10,000 Local Government Financing Vehicles (LGFVs) to fund the construction of roads, sewage plants and other infrastructure projects after a1994 budget law prohibited them from directly issuing bonds.2 These LGFVs are due to repay a record amount of debt this year. Moody's anticipates that a local government default could occur this year as 127 billion yuan ($21 billion)4 in LGFV notes will mature in the second half of 2013. Barring any preventative action by Premier Li, it would mark China's first onshore bond default.5 In an effort to mitigate these risks, the State Council ordered the National Audit Office to determine the extent of overborrowing by local governments that were using shadow banks, and a cash crunch was engineered in June by the People's Bank of China (PBOC) to target such lending practices by withdrawing liquidity from the interbank market raising the cost of borrowing dramatically.
However, there is a real possibility that the engineered liquidity crunch could worsen the country's economic contraction and potentially add to greater stress in the property and infrastructure sectors. For example, banking system nonperforming loans, which are reported at approximately 1.0% of total loans,6 could face significant upward pressure if economic growth continues to slow and lending becomes restricted.
In his current actions, Premier Li is acknowledging the risks brought on by the country's past credit boom and is clearly showing restraint in following the same actions as his predecessors to spur growth. The PBOC's recent actions and other reforms being presented by the new administration are designed to make over China's robust economy — this time with increased investment efficiency, which is critical to the long-term health of the country's financial system.
The opinions expressed herein are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This is not to be construed as an offer to buy or sell any financial instruments and should not be relied upon as the sole factor in an investment making decision. As with all investments there are associated inherent risks. This does not constitute a recommendation of the suitability of any investment strategy for a particular investor.