China’s central bank announced it has begun to reduce coronavirus-related stimulus early – a decision that may be far more relevant for policy evolution in developed economies than presently perceived. The move is part of Chinese policymakers’ renewed focus on risk control (see related blog on China), which reflects a belief that in order to sustain high quality growth, market discipline must be brought to bear on the weakest parts of the economy, including some state-owned enterprises, local government financing vehicles, and over-leveraged property developers. Indeed, the People’s Bank of China (PBOC) – mindful of the country’s high debt-to-GDP ratio and fast-developing financial markets – places a higher weight on financial stability risks than most central banks, and liquidity is often managed to mitigate the risk of asset price bubbles alongside traditional inflation and exchange-rate-stability objectives.
Policy tightening in China is already being felt domestically in the form of tighter money market liquidity, moderating private credit growth, and reduced government bond issuance. China’s credit impulse, a measure of changes in new public and private credit as a percentage of GDP, which typically marks turning points in economic activity, appears to have peaked (see chart below). We believe it’s likely to decelerate through the remainder of 2021. The central bank is targeting overall credit to grow in line with nominal GDP, implying the credit impulse will fall to around -3.5% of GDP by year-end, from a peak above 9% in the fourth quarter of 2020. All else equal, this may slow China’s economic activity to below-trend levels by late 2022.
New public and private credit issuance in China appears to have peaked
Source: CEIC, PIMCO as of 31 December 2020.
Tighter liquidity may mildly stress China’s corporate debt and money markets…
Tighter liquidity is likely to lead to stress at the periphery of China’s corporate debt market and, at least for short periods, more volatility at the heart of its money market. While Chinese regulators have adeptly isolated selective corporate debt defaults from the rest of the system, mounting debt incurred during 2020 (rising roughly 25 percentage points to nearly 300% of GDP) risks spillovers.
Second, at the global level, the current tightening in China’s credit impulse will occur amid strong fiscal stimulus and improving mobility in the developed economies. This stands in marked contrast to the backdrop of prior declines in the credit impulse in 2011-12 and 2014-15.
…but we expect a soft landing
The Chinese economy should achieve a soft landing for three main reasons:
- Banks and the larger economy are stronger. The prior round of credit tightening in 2017-18 made the economy more efficient and less sensitive to future stimulus withdrawal. It reduced excess low-end (and often unprofitable) manufacturing capacity. Simultaneously, policymakers took measures to bring hidden risks within the shadow credit sector back onto banks’ balance sheets and, in turn, pressured banks to raise capital and clean up their balance sheets. Banks are now well-placed to cope with a more neutral liquidity stance at a time when nonperforming loans are likely to rise.
- Pandemic’s economic effects have largely run their course. The authorities managed the pandemic so well that the private sector is in a reasonably good position to carry the growth baton after the role played by the public sector in 2020.
- Structural changes in the economy point to a less credit-intensive growth model than before. While the traditional manufacturing and investment-driven growth model has heavily relied on credit, the new economy is increasingly driven by the services sector and consumption. These sectors rely more on human capital and productivity, instead of credit.
- Higher spreads may offer opportunities in local duration. The potential for temporary periods of interbank risk aversion stemming from selective defaults and corresponding overshoots to interbank rates should offer good opportunities in Chinese local duration, which we view as fundamentally sound. Unlike previous cycles, the $273 billion rise in foreign holdings of Chinese government debt over the last two years implies a growing interconnectedness between Chinese and global bond markets.
- Renminbi appears attractive. On its own, the turn lower in the credit impulse does little to change our near-term constructive view on the Renminbi. As with the economy itself, the Renminbi tends to lag shifts in the credit impulse by two quarters. We also see potential currency upside from any U.S. tariff relief.
- Global demand should mitigate risks to commodity prices. Despite its past high sensitivity, the commodity complex faces less risk from a weakening credit impulse amid an expected strong rebound in developed economy demand.
- Developed economies may require stimulus for longer than currently appreciated. China provides a key engine of global growth, generating 11.4% of global GDP in 2020* and an annual average of 0.9 percentage points of growth in global GDP over the last decade. The years in which it contributed 0.5% or less – 2015, 2016, and 2019 – coincided with a material deceleration in global GDP growth. If past is prologue, developed countries may be required to maintain stimulus measures for longer than presently expected.
* In U.S. dollar terms. In purchasing power parity-adjusted terms, China’s share of, and contribution to the growth of, global GDP, are even larger, at 29% and 1.6% points, respectively.
Gene Frieda is a global strategist covering emerging and developed markets. Carol Liao is a China economist based in Hong Kong.