China’s Economy: Slowing,

Distorted and Debt-Addicted

Marcus Wright

Senior Economist, RBS, February 2016

China – the problems behind the headlines

China’s economy is:

• Slowing – GDP growth has slowed more than the headline

figures suggest, investment and production in particular

• Distorted – overly reliant on investment with little sign of

rebalancing

• Debt-addicted – a post-crisis debt build-up that is proving hard

to shake off

• Coupled with ad-hoc and uncoordinated policy we believe

China is more likely in a hard landing than a ‘bumpy landing’.

GDP growth – always on the money

4

6

8

10

12

14

16

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

China GDP Growth

v Target

Government Target GDP Growth

Source: Bloomberg

0

5

10

15

20

1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

China GDP (% Y/Y Change)

GDP (Official)

GDP 'Proxy'

Source: Bloomberg, Macrobond

• China’s GDP growth figure

always comes in remarkably

close to target

• And it’s never revised

• By the admission of the

Prime Minister GDP data is

“unreliable”

• It’s difficult estimating

China’s ‘true’ growth rate

• But a figure of around 3-4%

seems reasonable.

But investment has slowed sharply

-10

0

10

20

30

40

50

60

2011 2012 2013 2014 2015

China - Investment by Sector(y/y growth)Real Estate

Infrastructure

Manufacturing

Source: Bloomberg

• China’s post-crisis investment

boom is unwinding.

• Demand weakness at home

and abroad, as well as existing

excess capacity, has dented

manufacturing investment

growth.

• The property market is starting

to work through the inventory

overhang. But property

investment has stopped

growing. -30

-20

-10

0

10

20

30

40

China Housing Market (Construction and Sales, y/y change)

houses newly started

houses under construction

houses sold Source: Bloomberg

And so has industrial production

70

75

80

85

90

2

4

6

8

10

12

14

16

2011 2012 2013 2014 2015

China - Industrial Production

and Capacity

Industrial Production - y/y change - lhs

Capacity Utilisation - rhs

Source: Bloomberg

-20

-10

0

10

20

30

40

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

China - Cement, Steel & Electricity

Production (y/y change, 4mma)

Steel Cement Electricity

Source: Bloomberg

• All the years of excess

investment has left a legacy of

excess capacity.

• And the slowdown in

investment means China’s

heavy industries are having a

tough time of it.

• Electricity, cement and steel

production are all experiencing

y/y declines.

The disinflationary winds blow

-5

0

5

10

15

20

25

30

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

China - GDP and Deflator(y/y % change)

Deflator

Real GDP

Nominal GDP

Source: Bloomberg

-8

-6

-4

-2

0

2

4

6

8

2010 2011 2012 2013 2014 2015

China - Inflation (% y/y change)

Producer Prices

Consumer Prices

Core Consumer PricesSource: Bloomberg

• And all that excess capacity is

weighing down on prices.

• Producer price deflation is

running at close to four years.

• And tellingly the GDP

‘deflator’(a wider gauge of prices

in the economy) has turned

negative.

• Domestic price falls and a

falling currency means

significant disinflationary winds

are blowing from China. Those

‘made in China’ goods are

getting cheaper.

Exports and exporting excess capacity

100

150

200

Dec/2013 Jun/2014 Dec/2014 Jun/2015 Dec/2015

China - Volume of Steel Exports(Dec 2013 = 100)

Source: Bloomberg

• Chinese exports are struggling.

• And the volume of Emerging

Asia (predominantly China)

exports have been declining

since the spring of 2015.

•But China’s steel exports have

doubled in just two years.

• It’s a symptom of the build-up

of excess domestic capacity and

is driving global prices down.

-15%

-10%

-5%

0%

5%

10%

15%

20%

Jul/2013 Jan/2014 Jul/2014 Jan/2015 Jul/2015

China Exports (Y/Y Change)

USEUTotal ($)Exports from Emerging Asia (Volume)

Source: Macrobond, CPB

• China is on path trodden by

South Korea and Japan before

it where rapid economic

development is pursued

through a high investment to

GDP ratio.

• But China is an outlier

compared to the history of

those countries.

• And it’s an outlier when

compared to other emerging

markets, and has been so for

some time.

China’s investment level – out on a limb

15%

25%

35%

45%

1 11 21 31

Investment as Share of GDP (%)

China (1996-2014)

Japan (1955-1985)

S. Korea (1976-2006)

Source: IMF

10

20

30

40

50

2000 2002 2004 2006 2008 2010 2012 2014

Investment as Share of GDP (%)

China

Indonesia

India

Malaysia

Mexico

Brazil

Hungary

Philippines

Poland

Russia

S.Africa

TurkeySource: IMF

Rebalancing at a snail’s pace, if at all

30

35

40

45

50

55

1978 1982 1986 1990 1994 1998 2002 2006 2010 2014

China - Consumption v Investment as

% of GDP

Household Consumption InvestmentSource: Bloomberg

30

35

40

45

50

55

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

China - Manufacturing and Services

as share of GDP (%)

Services

Manufacturing

Source: Bloomberg

• Services as a share of GDP has

risen sharply in recent years.

• But that is attributed to the

build-up of financial services in

tandem with the stock market

rise.

• Economic rebalancing was in

desperate need on the eve of

the crisis. Instead, policy choices

distorted the economy further.

• The distortion is many years in

the making. Unwinding the

distortion will likely take years.

More signs of a lack of rebalancing

30

40

50

60

70

80

1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

Share of Total Labour Compensation

in GDP (%)

China US

S.Korea Indonesia

Japan

Source: Conference Board

• The volume of imports into

emerging Asia (predominantly

China) is contracting, a rare

phenomenon.

• Falling labour share of GDP is

a phenomenon seen across

many countries (owners of

capital taking an ever larger

share of the fruits of growth).

• But it was already low in

China and has only just begun

to turn.

-20%

-10%

0%

10%

20%

30%

40%

1994 1997 2000 2003 2006 2009 2012 2015

Emerging Asia Import Volume

Source: CPB World Trade MonitorAsian crisis

Tech

bubble

burst

Global Fin.

Crisis

Loans are supposedly not in great demand…

3

4

5

6

7

50

60

70

80

90

2009 2010 2011 2012 2013 2014 2015

China - Lending Rate

v Loan Demand

Index of Loan Demand - lhs

Benchmark 1 year Lending Rate - rhs

Source: Bloomberg

• Loan demand had

supposedly dropped sharply in

China, despite the fall in

interest rates

• But although growth in the

stock of credit growth has

cooled it remains very strong.

0

10

20

30

40

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

China - Credit

Growth(Outstanding,

Y/Y Change)

Source: Bloomberg

11.4%y/y

Just when you think they’re getting on top of all that credit…

0

500

1,000

1,500

2,000

2,500

3,000China - Aggregate Financing

(RMB Billions)

Source: Bloomberg

-100%

0%

100%

200%

300%

-20%

0%

20%

40%

60%

Jan/2014 Jul/2014 Jan/2015 Jul/2015

China - Loan and Corporate Bond

Growth (Y/Y Change)

Loans - lhs Corporate Bonds - rhs

Source: Bloomberg

•China has had periods of

cooler credit growth. The

problem is they are not

sustained. The debt addiction

is proving hard to shake.

• December 2015 saw strong

credit growth with bond

financing picking up.

• The concern is that current

borrowing is good money after

bad, with a lot going to finance

existing debts.

How can this debt build-up be pain free?

15

18

21

24

27

30

33

100

120

140

160

180

200

220

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

China - Debt to GDP

and Debt Servicing (%)

Debt to GDP - lhs

Deby Servicing Costs as % of GDP - rhs Source: BIS, Bloomberg

• $6.5bn per day – the rise in

China’s non-financial private

sector debt since the crisis.

• As we have previously stated,

a similar pace of debt increase

in other countries has led to a

financial crisis.

• The burden of China’s debt

build-up debt has led to a sharp

rise in debt servicing costs.

• The rise in corporate sector

debt in China and Hong Kong is

staggering. -40

-20

0

20

40

60

80

100

Corporate Sector Debt(% of GDP Change since Crisis)

Source: BISNon-financial Corp Sector

Forget equities, look at policy

• 2016 has been marked by falls in China’s currency and equities.

• The equity sell-off tells us little about China’s wider economy.

But the policy response does.

• In recent months economic policy in China has been reactive,

ad-hoc and seemingly uncoordinated between state institutions.

• And more fundamentally it shows there is a reluctance on the

part of the authorities to let the market have the final say in the

setting of prices in the economy.

The problems with pushing ahead with reforms

• Policy makers’ reluctance over market reform reflects two things

1. Conflict within the Chinese Communist Party (CCP)

about reform. Vested interest groups appear more

entrenched than previously thought.

2. Letting the market have the final say in the setting

of prices too readily conflicts with the CCP’s aims of

social stability and therefore the primacy of the Party.

• Authorities struggling with macroeconomic management and

crisis mitigation more than previously thought.

• This gives us less confidence the CCP can do/ will do the right

thing when it comes to reform and cleaning up the banking sector.

…and finally

• China’s debt binge – which has yet to begin unwinding –

remains too readily dismissed by the consensus.

• Our previous view of China experiencing a ‘bumpy’ landing is

changing. A ‘hard-landing’ is now the most likely scenario.

• China’s slowdown is already impacting the global economy

through the channels of growth, trade, inflation, interest rate

expectations and financial linkages. There is more to come on

all these fronts.

•We will elaborate more on this view and the impact it will

have on the UK and global economies in a future release.

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