While we await the annual National Peoples’ Congress and the ensuing announcement on growth targets and other reform initiatives, China’s economy has been on a steady path of muddle-through deceleration for the last couple of years especially given the high base in GDP it has attained. We believe the market currently underappreciates to what extent China’s economy is domestically led. Three relevant threats loom large over the next 3 to 6 months:
Tighter fiscal conditions: Fixed asset investment (FAI) in projects newly started, a key leading indicator of capital formation, has been slowing as local governments are cash-strapped following a collapse in land sales and property-related tax collections, which constitute 36% of local government revenues. In addition, local governments now face scrutiny and stricter regulation of projects. Although the central government is expanding its fiscal deficit to provide more support for infrastructure spending, this alone will not be enough to offset the drop in local government FAI spending as central government FAI is much lower – only 5% of the amount of local government FAI.
Financial and monetary conditions are restrictive: Repeated measures to loosen liquidity through targeted and wider easing measures have been inadequate. The O/N and 7-day repo rate continue to stay elevated since January and are yielding above levels two rate cuts ago. This compounds the upward pressure on real rates with the prevailing disinflationary environment and will worsen debt repayment capacity for borrowers. Non-performing loans are increasingly realized by larger state-owned banks indicating rising financial stress levels. On the FX front, despite slightly weaker USDCNY fixings by the PBOC, the CNY real effective exchange rate (REER) has appreciated markedly due to the moves from the EUR and JPY weights in the basket.
Property sector overhang: Looking at a simple average of property prices in 70 major cities, we estimate property prices have declined ~5%yoy in February, driven in part by ongoing oversupply and inventory pressure. Floor space under construction has been exceeding floor space sold and the adjustment here will have macro implications.
Our investment view expects a gradually weaker CNY vs USD, but it should remain an outperformer against other major currencies. Broad stability is still needed as a policy to instill confidence in the internationalization of the currency. This will lead to more pressure on export related industries and credit trends in this area will face deterioration. Overweight duration positions in local rates should perform once liquidity conditions ease further. For China USD-denominated credit broadly, we find valuations attractive vs US and other Asian investment grade credits. Even for cyclical sectors like industrial and property, we are able to identify quality issuers from our bottom-up analysis where margins can provide adequate cushion against these headwinds. Some may also benefit from policy relaxation in targeted areas.
There has been a lot of talk recently of the growth in the shadow banking system. Much of this growth has come in consumer credit as banking regulations have forced traditional bank lenders out of certain markets due to stringent capital requirements. With additional provisions of Dodd-Frank, Basel III, and other regulations of the banks coming online over the coming months and years, more lending products that were traditionally originated by the banking institutions, will now be moved to the non-bank entities, in our opinion, as many of the consumers who accessed this credit from the banks still need to obtain that financing. Peer-to-peer lenders (also known as marketplace lenders), specialty finance companies, and other financial firms, have stepped up in recent years to fill the void left by the banks. Others are likely to follow, in our opinion.
Shadow banking prior to the 2008/2009 credit crisis was just one of the many problems that led to the financial meltdown. Regulators failed to keep this market in check prior to the crisis, and investors failed to see the risk inherent in the lending by these entities prior to this time period. With the passage of Dodd-Frank and the creation of the Consumer Financial Protection Bureau (CFPB) in 2011, regulators appear to be better armed to deal with the issues posed by shadow banking this time around. Regulators are only one of the gatekeepers though. Investors will need to remain diligent in their credit analysis and proceed more cautiously when buying bonds backed by loans originated by “shadow banking firms”.
The CFPB already appears to have recognized the need to step in to regulate some of the non-bank entities. Recently, they issued a proposal that would effectively give them regulatory oversight over approximately 90% of the non-bank auto lending companies. This is a good first step in ensuring that the consumer is protected and the non-bank auto lenders are doing what they say they are going to do in terms of underwriting, servicing, etc.
Regulation, as seen from the recent crisis, does not guarantee there will not be a failure in the system. Not only was the unregulated shadow banking system one of the many issues that lead to the financial crisis, lapses by some in regulatory bodies failed to catch the additional risks that were created by many of the non-bank finance companies as well as risks embedded in the balance sheets of regulated financial institutions.
Since the financial crisis, the shadow banking system has had good performance due to an improving economy. It remains to be seen how some of the borrowers using these lending products will perform in a recessionary environment. Regulators will need to balance the need for these entities to provide credit to worthy borrowers while attempting to prevent the shadow banks from causing financial distress to borrowers and an endemic risk to the overall financial system. As always, investors that perform their own diligent analysis should be able to navigate their way through this sector and find attractive investment opportunities as the market evolves.