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What If China Turns To Austerity Rather Than Stimulus?

The current popular view is that in response to the Covid-19 problem, the central bank will stimulate, and this will support the local, and therefore global economy. One reason why markets are sanguine.

There is just one problem with this. China’s Global Times (one external voice of the Government) headed a piece “China should get ready for belt-tightening following virus outbreak”. Maybe China will not stimulate the economy by rolling out another massive monetary stimulus. This is potentially a game changer.

With the Chinese economy taking a major hit from the outbreak of the novel coronavirus pneumonia (COVID-19), the central government appears to pursue fiscal austerity as part of the efforts to pull through the difficult times.
While it is generally expected that fiscal stimulus and monetary easing will undoubtedly be the two main tools of central authorities for alleviating downward pressure on the economy and for maintaining macroeconomic stability, given the past experience and the financial risks currently facing China, a flood of spending programs seems no longer on the financial regulators’ list of choices for stimulating the economy.
“China will face decreased fiscal revenues and increased expenditures for some time to come, and the fiscal operation will maintain a state of ‘tight balance.’, Chinese Finance Minister Liu Kun wrote in an article published on Qiushi, a magazine affiliated with the Communist Party of China Central Committee. In this situation, it won’t be feasible to adopt a proactive fiscal policy by expanding the fiscal expenditure scale. I, and instead, policies and capital must be used in a more effective, precise and targeted way,” Liu said. Chinese Finance Minister Liu Kun wrote in an article published on Qiushi, a magazine affiliated with the Communist Party of China Central Committee.
Liu’s article sent a clear signal that China would not stimulate the economy by rolling out another massive monetary stimulus.
Due to the major impact of the coronavirus outbreak on businesses across the country, the Ministry of Finance has already made it clear that it would continue to reduce the tax burden on enterprises, which will undoubtedly weigh down the already slowing fiscal income. And a potential decrease in fiscal revenues directly points to the limited room for splashing out on unnecessary programs. China’s fiscal revenues grew 3.8 percent in 2019, the slowest growth since 1987, while fiscal expenditures during the same year gained 8.1 percent compared with the previous year, outpacing economic growth.
Therefore, to maintain a “tight balance,” the Chinese economy will have to tighten its belt by curbing non-essential expenditures while expanding investment in a precise and targeted manner.
There has been a consensus call among economists and economic observers for the fiscal deficit ratio to break the 3 percent GDP mark temporarily so that more space could be given to fiscal expenditures to stabilize the economy amid the epidemic.
However, it should be noted that fiscal space constraint is not the key reason for belt-tightening. Past experience with massive stimulus already showed that a flood of investments could lead to many consequences like high levels of local government debts, and to the detriment of high-quality economic growth.
In 2019, China’s fiscal expenditures reached 23.9 trillion yuan ($3.4 trillion), of which only 3.5 trillion yuan was spent by the central government, and the rest by local governments.
In this sense, governments at all levels should be prepared for belt-tightening in the future to come.

This could have significant consequences for us all!

Will The Coronavirus Hit Growth?

We look at what the economists are saying about the potential impact. Tourism and exports are likely to be hit – and these are significant to the Australian economy. More broadly, will global growth be hit?

Coronavirus will hurt spending in China, with spillover to global companies

On 29 January, the World Health Organization said that China’s coronavirus has infected nearly 6,000 people domestically so far, with an additional 68 confirmed cases in 15 other countries. The primary impact is on human health. However, the risk of contagion is affecting economic activity and financial markets. The immediate and most significant economic impact is in China but will reverberate globally, given the importance of China in global growth as well as in global company revenue. By sector, the coronavirus will likely have the largest negative impact on goods and services sectors within and outside of China that rely on Chinese consumers
and intermediary products. Via Moody’s.

China’s annual GDP growth forecast unchanged so far, but composition could shift

In our baseline, we expect the outbreak to have a temporary impact on China’s economy and for annual GDP growth in China to remain in line with our forecast of 5.8% in 2020. However, the composition of growth will likely shift because of a dampening of consumption in the first quarter, potentially offset by stimulus measures. Nonetheless, there is still a high level of uncertainty around the length and intensity of the outbreak, and we will review our forecasts as conditions evolve.

Following the outbreak of Severe Acute Respiratory Syndrome (SARS) in 2003, growth and financial markets in China weakened significantly, but for only a short period. An offsetting rebound limited the overall negative effects on annual growth. But the SARS episode is not a perfect comparison, since the composition of the Chinese economy has changed appreciably since 2003.

Over the past 16 years, the contribution of consumption to China’s economic growth has risen significantly. Therefore, the impact of the coronavirus through the consumption channel may well be higher now. If there is indeed a sharp slowdown in consumption, we would expect macroeconomic policy to be eased in response. This could lead to a shift in the drivers of growth in 2020.

The virus will likely have an effect on the revenue of China’s discretionary travel, transportation, lodging, restaurants, retail and services sectors. However, the impact on offline retail sales could be smaller compared with the weakness following the SARS outbreak because of the rapid shift to online sales in China over the past decade. Non-discretionary consumer demand related to the healthcare sector and medical equipment will likely surge.

Chinese authorities have been proactive in taking quarantine measures to contain the infection, including closing public transportation in some cities and conducting screening in major transportation centers. These measures help contain the spread of infection and promote early treatment, although they add costs and constrain economic activity.

Among the challenges of containing the coronavirus include that it can be contagious during the incubation period, and many of those infected or potentially infected traveled ahead of the Lunar New Year. The next few weeks will be vital for determining the extent of infection and the effectiveness of the quarantine measures.

Loss of productivity will likely weigh on domestic supply as a result of sickness, furloughs, and potential delays in manufacturing production given the government’s decision to extend the Lunar New Year holiday. This situation will likely also reduce private investment, but this effect will be secondary to the effect on consumer spending, and will also depend on the macroeconomic policy response.

Hubei province will bear the brunt of economic impact

The outbreak began in Wuhan, the capital of Hubei province and the key transportation and industrial hub in central China. The economic effects on the local area will be significant. Hubei province had expected to record a regional economic growth rate of up to 7.8% in 2020 according to the local authorities, 200 basis points higher than our forecast for China’s total economy. As China’s ninth-most populous and seventh-highest province by GDP, a slowdown in economic activity will pose significant repercussions for the country as a whole.

Hubei’s role in linking China’s eastern coastal area with the central and western regions will extend the ripple effect on neighboring cities and provinces with a higher reliance on service sectors and with higher population densities.

China’s size and interconnectedness amplifies global impact

The fear of contagion risk is already evident in global financial markets. In addition, the negative spillover will also affect countries, sectors and companies that either derive revenue from or produce in China. China has an even higher share in world growth and is even more closely connected with the rest of the world than during the SARS episode. If the outbreak spreads significantly outside China, the burden on healthcare sectors in other affected countries will potentially increase. The revenue of companies and sectors that rely on Chinese demand will be affected as that demand dampens.

The outbreak will also potentially have a disruptive effect on global supply chains. Global companies operating in the affected area may face output losses as a result of the evacuation of workers. Companies operating outside China that have a strong dependence on the upstream output produced from the affected area will also be under pressure because of possible supply chain disruptions resulting from temporary production delays.

Other Asian-Pacific economies are vulnerable to a decline in tourism from China

The outbreak will take a toll on tourism sectors elsewhere in the region, and places outside the region that receive tourists from China. The initial outbreak occurred a few weeks before the Lunar New Year, which has increasingly become a popular time to travel. China has imposed travel bans on outbound group tours to contain the spread of the virus. The fear of contagion could dampen consumer demand and affect tourism, travel, trade, and services in Hong Kong, Macao, Thailand, Japan, Vietnam and Singapore, which have been the top destinations of Chinese tourists in recent years.

China’s National Immigration Administration recorded outbound travel grew about 12% year-on-year to 6.3 million trips during the 2019 Lunar New Year. Following the SARS outbreak, tourism fell sharply in most of these economies, particularly in Singapore and Hong Kong, which were also subject to a relatively high number of infections. We expect the risk of potential negative spillovers to domestic tourism in neighboring countries to be higher than during SARS because Chinese nationals now make up the largest share of visitors to other Asia-Pacific economies. The timing is particularly bad for Japan as it seeks to rebound from the dip in consumption, and presumably real GDP growth, in the last quarter of 2019 following a sales tax hike.

Australia Is Too “China Dependent”: Rudd

Kevin Rudd has warned Australia is too “China dependent” in economic terms, and must diversify its international economic engagement. Via The Conversation.

Setting out principles he believes should govern the way forward in dealing with China, the former prime minister said for too long Australia had been “complacent in anticipating and responding to the profound geo-political changes now washing over us with China’s rise, America’s ambivalence about its future regional and global role, and an Australia which may one day find itself on its own”.

Launching journalist Peter Hartcher’s Quarterly Essay, Red Flag: Waking up to China’s challenge, Rudd said Australia needed a regularly-updated “classified cabinet-level national China strategy”.

This should be based on three understandings. The first was that “China respects strength and consistency and is contemptuous of weakness and prevarication”.

The others went to awareness of China’s strengths and weaknesses, and of Australia’s own strengths, weaknesses and vulnerabilities.

Rudd, who was highly critical of the government, declared “Australia needs a more mature approach to managing the complexity of the relationship than having politicians out-competing one another on who can sound the most hairy-chested on China”. This might be great domestic politics but did not advance the country’s security and economic interests.

Australia should “maintain domestic vigilance against any substantive rather than imagined internal threats” to its political institutions and critical infrastructure.

He fully supported the foreign influence transparency act, but he warned about concern over foreign interference translating “into a form of racial profiling”.

“These new arrangements on foreign influence transparency should be given effect as a legal and administrative process, not as a populist witch-hunt” – a return to the “yellow peril” days.

Rudd said Australia must once again become the international champion of the South Pacific nations, arguing the government’s posture on climate change had undermined Australia’s standing with these countries and given China a further opening. “The so-called ‘Pacific step-up’ is hollow.”

Australia should join ASEAN, Rudd said; this would both help that body and assist Australia to manage its long term relationship with Indonesia.

On the need to diversify Australia’s international economic engagement, Rudd said: “We have become too China-dependent. We need to diversify further to Japan, India, Indonesia, Europe and Africa – the next continent with a rising middle class with more than a billion consumers. We must equally diversify our economy itself.”

Rudd argued strongly for Australia to continue to consolidate its alliance with the United States.

But “Australia must also look to mid-century when we may increasingly have to stand to our own two feet, with or without the support of a major external ally.

“Trumpist isolationism may only be short term. But how these sentiments in the American body politic translate into broader American politics with future Republican and Democrat administrations remains unclear.”

Rudd once again strongly urged a “big Australia” – “a big and sustainable Australia of the type I advocated while I was in office.

“That means comprehensive action on climate change and broader environmental sustainability,” he said.

“Only a country with a population of 50 million later this century would begin to have the capacity to fund the military, security and intelligence assets necessary to defend our territorial integrity and political sovereignty long term. This is not politically correct. But it’s yet another uncomfortable truth.”

Author: Michelle Grattan, Professorial Fellow, University of Canberra

China’s New Prime Rate Mechanism Makes Banks More Risky

On 17 August, the People’s Bank of China (PBOC), the central bank, announced reforms to the loan prime rate (LPR) mechanism. Via Moody’s.

Beginning on 20 August, the new LPR will average the lending rate quoted by 18 banks on that same day to determine the lending rate for all banks when they originate new floating rate loans. This process will then be repeated on the 20th of each month.

This reform will narrow Chinese banks’ lending margins, a credit negative. The narrower margins on loans will also encourage banks to increase their risk appetite and, as a result, weaken asset quality.

According to the PBOC, the National Interbank Funding Center will announce the new LPR at 9.30am on the 20th of every month.

A five-year tenor will be added to the existing one-year LPR to serve as a reference rate for banks pricing long-term loans such as mortgages. To expand the representativeness of the LPR, the PBOC also included eight small banks – including two city commercial banks, two rural commercial banks, two foreign banks and two private-invested banks – to the existing 10, including state-owned and joint stock commercial banks, participating in LPR quotations. Banks’ use of LPR as a pricing reference will be included into and evaluated by China’s Macro Prudential Assessment.

The new mechanism liberalizes interest rates because it will explicitly replace the current loan pricing based on benchmark rates, which are not sensitive to changes in market rates. Under the current practice, introduced in October 2013, 10 banks decide the LPR on a daily basis. This gives them little incentive to price their LPR differently than the PBOC’s benchmark lending rate, which has not changed since October 2015. Although this mechanism was designed to approximate market-oriented interest rates, the actual rate has closely matched the government’s benchmark lending rate. In recent months money market rates and bond yields have declined substantially but actual bank loan rates have remained high, resulting in a wider gap above market interest rates, protecting Chinese banks’ lending margins.

The new LPR formation will be based on open market operations (OMO) rates, mainly the one-year interest rate of the medium-term lending facility (MLF) combined with a premium to reflect bank’s own funding cost, risk premium and credit supply and demand. The PBOC created the MLF in September 2014 to provide banks with medium-term funding typically for three-months to one-year. As of 15 August, the MLF interest rate is 3.3%. We expect the PBOC will increase the frequency to adjust the MLF interest rate to better reflect market rates.

Because of current market conditions, the implementation of the new LPR loan pricing mechanism will directly weigh on bank rates on new loans and lower their net interest margins. We expect that the banks with large loan exposures due for re-pricing in the near-term will be more immediately exposed. The actual impact over time will also be affected by differences in bank’s asset mix, revenue mix, the credit profile of borrowers and cost management.

We expect that the banks’ narrowing margins on traditional loans will prompt some banks to increase their risk appetite, potentially weakening asset quality. For example, banks could shift their investment portfolios to high yield bonds and other high-yield investments from low yield Treasury bonds and investment-grade bonds.

From a risk-management perspective, the new mechanism, by making loan rates more responsive to market rates, will increase banks’ exposure to market volatility and interest rate risk. The lack of a developed interest rate derivative market in China will add to this pressure by limiting banks’ ability to hedge or transfer this risk.

Rising Household Debt May Weigh on Medium-Term Chinese Growth

Chinese household debt has continued to rise rapidly, reaching 85% of disposable income at end-2018, Fitch Ratings says in a report published today. Rising debt servicing costs do not pose near-term risks to financial stability, but will weigh on economic growth in the medium term and this is reflected in our latest GDP forecasts.

Chinese household debt grew by 18.2% last year, slightly slower than in 2017 but still nearly double the rate of nominal GDP growth. They estimate that household debt rose to about 53% of GDP last year, up from just 18% a decade earlier. This increase was largely driven by mortgage borrowing, but has spread to other products such as credit cards, where the outstanding balance of debt was similar to the US, at about USD1 trillion at end-2018.

The household debt-to-disposable income ratio is lower than most developed markets. But the gap will narrow rapidly, with the ratio rising to close to 100% at the end of this decade if growth rates remain unchecked.

The rapid pace of household debt growth is more of a concern than the level. Closing the gap with international peers would add considerably to China’s macroeconomic vulnerabilities, given its already high corporate debt burden. Rising consumer credit could support economic growth and rebalancing towards consumption in the near term. In their latest Global Economic Outlook published on 17 June, they increased our forecast for annual real GDP growth this year slightly, by 0.1pp to 6.2%, as earlier policy easing appeared to have gained traction. But consumer indicators have been relatively soft.

2Q19’s yoy growth rate of 6.2%, released by the National Bureau of Statistics on 15 July and in line with our GEO forecast, is consistent with their view that following a stronger-than-expected first quarter, growth would slow before stabilising. Rising household debt may lead to overleveraging by individual borrowers, eventually becoming a headwind to growth as debt service costs rise at the expense of other discretionary spending. They reduced their 2020 growth forecast by 0.1pp to 6.0% in the GEO, and see growth slowing to 5.8% in our 2021 forecast. A sharp correction in property prices is a downside risk, given households’ significant exposure to housing loans.

Household debt accounts for just 18% of banks’ assets in China, lower than many other APAC jurisdictions. But several medium-sized banks have aggressively expanded their lending in the segment, given continued corporate deleveraging efforts. Ping An Bank stands out, with 84% of its loan increase in 2017-2018 in retail loans, especially credit cards.

Among securitised assets in Chinese consumer ABS deals, unsecured consumer lending, which is less regulated than secured lending, exhibits a worse performance. Secured loans, like housing mortgages and auto loans, have been robust despite rising household debt because they benefit from stringent underwriting guidelines stipulated by regulators, and low average loan-to-values provide significant buffers against declines in collateral market value.

Securitisation accounts for about 2%of Chinese banks’ funding source for household debt. Securitised assets, which have performed better than banks’ overall books, can provide a direct and granular insight about asset-specific performance. The performance of secured loans, like housing mortgages and auto loans, has been robust despite rising household debt because they benefit from good economic environment and stringent underwriting guidelines stipulated by regulators.

Another Chinese Bank Is Rescued

On 28 July, Bank of Jinzhou reported that some of its shareholders had sold a portion of their domestic shares to ICBC Financial Asset Investment Co., Limited, a wholly owned subsidiary of Industrial & Commercial Bank of China Co., Ltd.; Cinda Investment Co., Ltd, a wholly owned subsidiary of China Cinda Asset Management Co., Ltd.; and China Great Wall Asset Management Co., Ltd.

According to Bank of Jinzhou’s announcement, the transactions were conducted with the support and guidance of the local government and financial supervising authorities. ICBC and Cinda have announced their investment in the bank, while Great Wall has not confirmed the transaction. Via Moody’s.

The share sale is credit positive for the creditors of Bank of Jinzhou, which delayed the release of its 2018 annual report and suspended trading of its shares in April 2019 on the Hong Kong Stock Exchange. The three new shareholders are all institutions with strong financial resources, experience and government backing, which will support market confidence and could facilitate further measures to strengthen Bank of Jinzhou’s balance sheet and operations. ICBCFAI was established in 2017 to expedite debt-to-equity swaps and conduct distressed asset management business for ICBC. Cinda and Great Wall are two of the big four asset management companies in
China that handle distressed assets.

More generally, the share sale is also positive for other financially distressed regional banks because it shows that the Chinese authorities are focused on reducing potential contagion from failing regional banks. In the case of Bank of Jinzhou, the share sale will allow ICBCFAI, Cinda and Great Wall to take an active role in supporting the lender.

It also contrasts with the authorities’ takeover of Baoshang Bank in May 2019. The authorities initially opted to underwrite a significant amount of Baoshang Bank’s retail customers’ liabilities while having wholesale customers face some losses. However, they decided to underwrite almost all of the bank’s liabilities after the financial markets turned more volatile and smaller and regional banks faced funding pressure from the interbank market.

Although Bank of Jinzhou’s share sale and Baoshang Bank’s takeover may alleviate market fears of contagion risks and stabilise the banks’ credit quality, they will not fundamentally improve the financial standing of regional banks, many of which remain weak links in China’s financial system. In addition, the sale of the shares by some of Bank of Jinzhou’s original shareholders, though conducted at quite a deep discount to the bank’s last traded share price before the trading suspension and book value, could increase the risk of moral hazard.

The impact of the transaction, which indicates an expanding role for ICBC in supporting distressed regional banks, is immaterial to ICBC’s supported credit profile. However, the transaction could weigh, albeit marginally, on ICBC’s standalone credit profile. ICBC made the investment through ICBCFAI and Bank of Jinzhou will not be consolidated in ICBC’s accounts. ICBC could invest up to RMB3 billion in Bank of Jinzhou and reported RMB17.19 trillion in risk-weighted assets as at the end of 2018.

The investment in Bank of Jinzhou is also credit negative for the standalone credit profiles of Cinda and Great Wall, though it reinforces the likelihood that they, in turn, would receive support from the government because of their policy roles. The transaction consumes their capital and increases their contingent liabilities if they need to provide additional support to the bank. The two companies’ equity investments in the bank have a risk weighting of 250% and the resulting capital pressure will constrain their capacity to support other distressed banks through equity investment. At the end of 2018, Cinda’s core Tier 1 capital adequacy ratio was 10.21%, slightly above the minimum regulatory requirement of 9%.