The jury remains out for many investors on whether China can achieve a "soft landing" and deal with its debt in an orderly way - or will encounter more turbulence. The US bank has risen the red flag of alarm.

Debate still rages on whether fears about China’s economy, the world’s second-largest, are overblown, or whether there are potentially serious cracks that could open at any moment.

Stepping into the fray on the more alarmed side of the fence is Northern Trust. The Chicago-headquartered bank’s chief economist, Carl Tannenbaum, says the country has “accumulated debt at an extraordinary scale for a developing economy” and that this could “weigh heavily” on Chinese and global economic performance in the future.

Tannenbaum backs up his statement by noting that credit has driven economic growth in China to the extent that debt in the non-financial sector, which was stable before the crisis, expanded from 117 per cent of gross domestic product in 2007 to 210 per cent of GDP in 2015. Government and household debt are not high by international standards, but non-financial corporate debt is “huge” – at 170 per cent of GDP – and “worrisome”, he says in a note. 

His comments contrast with the position, as recounted by this publication in a recent interview, of Wells Fargo Asset Management portfolio manager Anthony Cragg, who says the number of gloomy predictions about China has declined in recent weeks. He said fund inflow data and market performance (such as gains in the MSCI China Index) bear this out. (To see that interview, click here.) Economic worries about China are “hugely” overstated, in his view.

Recent developments suggest Chinese policymakers are keen to reduce leverage in the financial system and wider economy, according to a note yesterday from Alquity Investment Management. It pointed out that the China Banking Regulatory Commission recently drafted new regulations for wealth management products (WMPs). These WMPs are central to China's “shadow banking system” and Alquity said the outstanding value of WMPs is estimated to be around a third of GDP.  

“While this will create short-term uncertainty, it represents another example of the government's commitment to reforms and stabilisation, and thus should be viewed as a long-term positive development that will ultimately serve to reduce systemic risk,” says Alquity. Unless there is a serious economic shock, a repeat of the stimuli in policy terms seen in the first quarter of this year is unlikely, it adds.
 

Debt pile
On the debt front, however, Northern Trust notes that despite a stated desire to rein in lending, credit growth continues and “total social financing”, a measure of credit flow to the Chinese economy, rose by about $1 trillion in the first three months of this year. That rise may have boosted growth in the short run, but spells danger, Tannenbaum reckons.

To put developments into historical perspective, Tannenbaum says China has far exceeded the predictions of those expecting higher growth after it joined the World Trade Organisation in 2001. Exports as a share of GDP surged, although exports were hit by the 2008 financial turmoil, and Chinese authorities nudged the growth of debt to take up the slack.

“The day of reckoning is not here yet. But history suggests that a debt build-up has consequences. In general, China’s economy and financial system are vulnerable and susceptible to shocks when there is a significant accumulation of debt. In the 1990s, Thailand and Mexico buckled under the burden of heavy debt. These are relatively small economies, and they had external debt issues. China is a large economy and faces domestic debt problems. The Japanese experience after the 1980s debt boom and the recent US financial crisis following a credit surge are closer to the Chinese situation,” says Tannenbaum. 

“There is widespread agreement that China’s debt is a threat to economic growth, but the course the economy will take is uncertain. Doomsayers suggest that banks are funded by unstable short-term wealth management products. A loss of confidence in banks could trigger a financial crisis,” he continues.

“The less sceptical argue that the People’s Bank of China will provide ample cash to banks experiencing non-performing loans. About a month ago, a senior Chinese bank regulator assured critics that the banking sector is 'stable and risks are under control'. The more pragmatic suggest that China could follow Japan, where sub-par growth and deflation prevailed as authorities postponed appropriate policy actions,” he adds.