Investors are still concerned about a hard landing in China despite better than expected second quarter GDP data at 9.5 percent and industrial production which was up 15.1 percent on an annual basis in June after rising 13.1 percent a month earlier. They are particularly focused on the potential for another financial sector crisis as the property bubble deflates and local government financing vehicles are unable to repay the massive amount of money they borrowed in 2009-10. Many analysts, as well as the ratings agencies, are anticipating a spike in non-performing loans in the banking sector in the medium-term. At the same time, the IMF has warned that “credit and asset price behavior is disconcerting in China and Hong Kong, showing boom-like dimensions.” The Fund drew comparisons with Japan’s 1985-89 credit and asset price boom, and warned that “in both economies credit growth remains high compared with run-ups to previous credit booms and busts, and there are mounting concerns about the potential for steep corrections in property prices and their implications.”
The combination of a deflating real estate bubble, high inflation, the extent of loans to local government financing vehicles that will turn bad, the potential surge in NPLs in the formal and underground banking systems, and renewed skepticism over corporate governance is expected to continue to dent investor appetite in the months to come. Several investors have noted that it is unusual for all three ratings agencies and a range of public and private analysts to warn of potential trouble a year or two in advance.
The definition of a “hard landing” in China differs from that in the rest of the world. The common definition is when an economy rapidly falls into recession either as a result of aggressive tightening to quell inflation or an abrupt internal or external economic shock. For China, most analysts agree that a slide in GDP growth to 7 percent which would slash job creation and drive up unemployment – and threaten social stability – would be a better description and could be what the country is facing in the next year. Already there have been widespread protests over wages on rising inflation, which have likely been bigger and more widespread than reported. With the 18th Party Congress scheduled for late next year for which there is division over potential leadership – with the two main contenders diametrically opposed on the way forward in terms of more economic and political reform – officials are expected to focus on maintaining stability.
Early crisis predictions that economic rebalancing, currency appreciation and banking industry modernization would accompany securities market rallies have been replaced with lower expectations and increased investor pursuit of difficult to access short positions across asset classes. Fixed-asset infrastructure investment remains the overwhelming GDP driver, the yuan has flattened against the dollar in the latest band and NDF settings, and foreign financial institution ownership and activity opening has been modest by the results released after the most recent bilateral SED meeting and comparable efforts. In equities, performance has been lackluster even with p/e ratios in the 20 range, half the previous peak, and last year’s IPO boom where Chinese listings led the world has also stumbled with offerings withdrawn before launch or soon selling at a discount. The disclosure scandals in the US which have imposed losses on well-known hedge funds are a reminder of lagging corporate governance standards which have surfaced equally in debt workout attempts with defaulted borrowers like Asia Aluminum. Through the first half of 2011 real estate developers in particular have placed a record $20 billion in the Mainland contingent in external bonds as a large CEMBI category. Primary issuance has stalled and secondary yields have jumped past 10 percent on slowdown and creditworthiness concerns, and the inability to seize underlying collateral through offshore structures. Chinese banks, to meet domestic regulatory and Basel capital-adequacy mandates, had relied on this route to backstop new private share-raising plans, but with current market reticence the rescue and recapitalization burden may again be left to public finances which never resolved the last decade’s episode as stimulus, local government, informal and property strains combine to complicate and magnify this period’s morass.