Risk drivers and outlook

We are about to see a changeover of the majority of the Chinese Communist Party leadership. However, political continuity will be maintained with Xi Jinping remaining firmly in power at a time of gradual slowdown driven by China’s economic rebalancing. The process is too slow as Beijing continues to support economic growth in order to preserve social stability. However, it also further fuels the rise of an already heavy domestic debt. Therefore, clouds are forming over a country steadily hit by large net capital outflows and a decline in the RMB value and foreign exchange reserves. Nevertheless, those reserves are still at a very high level and allow China to be classified in category 1/7 for short-term political risk.

Faced with external pressures, China has started to tighten some capital controls and raise interest rates. In the future, the Chinese economy will remain under pressure in the context of a strong USD, wide interest gap with the USA, weakened global trade (which could worsen if US President Trump triggers a trade war with China) and adverse domestic developments. The latter mostly concern the corporate debt spiral and the deteriorating health of the banking sector. Beijing has yet to draw up a decisive debt-reduction strategy for mainly state companies, recapitalise the banks and introduce better regulation for shadow banking. China’s two greatest structural risks are primarily domestic – as external debt is low – and to a great extent are mitigated by high household savings, the State’s strong net creditor position, low central government debt and its control on the most important corporate and banking players. Those buffers combined with political stability justify classifying China in category 2/7 for medium- to long-term political risk. Beijing acknowledges the need for reforms and for corporate debt reduction, as witnessed by various measures taken in past years. However, those are largely insufficient given the overwhelming scale of the problem. There are clear doubts about President Xi Jinping using a stronger second mandate to launch bolder reforms, including the restructuring of state companies. Therefore, the longer substantial reforms are delayed, the bigger the risks and consequences of a financial (and economic) crisis and the weaker the State’s capacity to withstand it. In a tricky and uncertain transition context with highly indebted companies, persisting industrial overcapacities and higher payment delays, China continues to be rated in the highest (C/C) commercial risk category.

Facts & figures

Pros

  • Political stability
  • Strong net international creditor
  • High savings rate
  • Large middle class

Cons

  • Resistance to reforms within the Communist Party
  • Socio-economic contract threatened by economic slowdown process
  • Enormous corporate debt caught in a vicious circle
  • Vulnerable banking sector burdened by bad loans and lack of transparency

President and General Secretary of the Chinese Communist Party (CCP)

  • Xi Jinping

Prime Minister

  • Li Keqiang

Next National Party Congress elections (five-year cycle)

  • Autumn 2017

Population

  • 1,371.2 million

Income per capita

  • USD 7,820

Income group

  • Upper middle

Main export products

  • Electrical machinery & equipment (20.6% of current account receipts), machinery & mechanical appliances (14.5%), textiles (10.4%), factor income (8.6%), base metals and articles (6.7%), tourism (4.3%)

Country risk assessment

Continuity amid political changes 

The National Party Congress (NPC) next autumn will be a significant event as most of the CCP’s leaders are expected to be replaced, within both the Central Committee (CC) and the key Politburo Standing Committee (PSC). The process is expected to be smooth and ensure future political stability. As for Xi Jinping, who is expected to bring more allies within the CC, his presidential mandate will be extended for another five years in March 2018. In fact, a question mark hangs over Xi’s potential third term. Based on the growing centralisation and personalisation of power during his first term, staying in power for longer as president, i.e. until 2027, is not ruled out but it would require a constitutional change. Hence, he might instead prefer to seek a 3rd term as General Secretary. The PSC composition and potential change of unwritten election rules (i.e. the retirement age and the two-term limit for the General Secretary) will give an indication of Xi’s current political strength.

Meanwhile, he will pursue the nationwide campaign against corruption that hits low- and high-profile party members without distinction, from State-owned enterprise (SOE) executives and local governors, to military and security chiefs and even an ex-PSC member. His policy is appreciated by the Chinese population. However, at the same time, it increases political resentment, since it affects the privileges of party members. As a result, political defiance, especially at local level, could increase and become a factor of future political instability. Xi’s authoritarian rule goes hand in hand with heightened media censorship and hardened security forces to reduce social instability risks.

Rising social protests at local level are indeed a threat to the CCP’s legitimacy in a structurally slowing economy where the manufacturing industry is seeing its economic share shrink. Worker protests are fuelled by increasing wage arrears and will rise further with the planned 1.8 million lay-offs in the overcapacity coal and steel sectors in the next two years. Moreover, the CCP is facing the growing exasperation of the middle classes concerning poor public health, particularly sky-high air pollution in the metropolises, and needs to find acceptable solutions to maintain its credibility.

China’s international weight to gain from potential US isolationism

China’s foreign policy is run from two angles. The first consists in geostrategic positioning and economic development plans to defend its economic interests worldwide. The modern version of the Silk Road under the “One Belt, One Road” initiative highlights this. Enhanced cooperation with governments in countries where infrastructure projects are planned allows Beijing to record substantial trade and economic benefits while increasing its political weight on the world scene through mutually advantageous relations. China is also actively promoting its role as a financing provider by setting up new international institutions (e.g. AIIB) and as a free trader (e.g. the planned “Regional Comprehensive Economic Partnership”). Facts show that China increasingly contests US political and economic world dominance, a trend that could accelerate in the event of a more isolationist US policy.

The second angle threatens future security and consists in China’s regional policy whereby it affirms its regional political and military power by increasing its military presence in the South China Sea (SCS) and East China Sea. As Beijing considers the former as its historical mare nostrum, it is expected to continue building artificial islands in disputed maritime areas. Despite the unfavourable international ruling on sovereignty issues by the UNCLOS tribunal last July, China’s assertiveness and growing presence will not stop. Therefore, tensions will inevitably rise at some point, with the risk of violent clashes with Japan, Vietnam and the Philippines. In the short term, tensions with those countries are unlikely given recently improved ties with the governments of the latter two countries.

South China Sea and an uncertain US policy on the security agenda

Since President Trump’s election, the biggest conflict risk factor could come from the new US policy in the region, potentially contesting the status quo with China, the long-term number one US rival. Not only a trade conflict but also a fluctuating US stance towards Taiwan, a tougher position on North Korea and clashes between US and Chinese vessels in the SCS could dangerously affect regional security. Sovereignty issues are non-negotiable for Beijing and would inevitably lead to retaliation if badly addressed. An uncertain US Asian policy and Taiwan’s nationalist but cautious president could certainly fuel regional instability in the medium term. However, Mr Trump’s recent announcement to stick to the One China policy has so far removed the risk of tension.

Domestically, besides sporadic violence in the Xinjiang region, the main source of tensions could come from Hong Kong. At the end of March, a new CEO is to be elected in the context of heightened opposition to Beijing’s intervention in the island’s political landscape and tightening control on civil liberties. Potentially significant tensions are expected as universal suffrage, as foreseen in the Basic Law, will not be applied. Beijing will stay inflexible to avoid contagion to the mainland. Pragmatism should prevail in the end.

Pro-growth policy vs. economic rebalancing

Ever since 2011, China’s growth has been constantly slowing. Real GDP grew by 6.7% in 2016 and should gradually fall to 6% in the medium term. This year, Beijing will take the necessary measures to keep it at around 6.5% and maintain stability until the NPC. Beijing is expected to reduce stimuli and tighten its monetary policy as domestic pressures have increased in the face of widening imbalances. After a sharp rebound in prices, the government is expected to cool down the overheating property sector by cutting the excessive loans that have contributed to corporate debt rising further to extremely worrying levels. Inflation is again on the rise (above 2%), after having flirted with deflation, on the back of higher commodity and food prices.

Economic rebalancing is underway as evidenced by the economy’s soft landing, a dominant services sector and steadily strengthening consumer demand. However, government policies don’t really point to a firm commitment to an economic model change. The transition to a consumption-led economy is far too slow, as demonstrated by China’s persistent reliance on domestic investments (still at a high 43.7% of GDP in 2016) and robust – but forecast to decrease – current account surplus. Shaken by a negative trend in net capital flows, the balance of payments has fallen into overwhelmingly negative territory since 2015 and is forecast to remain in deficit in the MLT. It reflects China’s structural developments, notably stronger Chinese FDI fuelled by increasing overseas acquisitions from Chinese groups expanding internationally, and a sustained capital flight since 2014.

Controls tightened to stem capital outflows and RMB decline

Capital outflows brought the RMB down to its lowest level against the USD since 2008 after a 7% drop in 2016. The RMB is now more market-driven and managed against a broader basket of 24 currencies to alleviate market pressure from the USD. However, even though it has appreciated slightly against this basket, the RMB has become more volatile since the surprise 3% devaluation against the USD in August 2015. Given Beijing’s eroded credibility since then, China’s top external risk will persist due to expected further net capital outflows and RMB depreciation (Beijing aims to allow it at a gradual pace) fuelled by the Chinese economic slowdown, the widening interest gap with the USA as the Fed plans to accelerate rate hikes, and a strong USD. To stem capital outflows, last November the People’s Bank of China (PBC) introduced restrictions on outbound FDI, notably in non-core business, to prevent disguised capital flight and tightened some capital controls (e.g. on dividend remittances and on foreign currency purchases by individuals), reminding us that its capital account is only partially open. Further additional capital controls are possible but unlikely to target cross-border trade flows directly. However, recently tightened capital controls on RMB transfers could temporarily affect international business in RMB and Beijing’s promotion of the RMB as a major international currency.

Those decisions, the impact of which seems to have been felt since the end of 2016, highlight the deteriorating business environment, with more uncertainty ahead. Several interest rate hikes seem increasingly likely in spite of the negative effect it could have on highly indebted companies. Last but not least, the RMB could also be affected by trade tensions during Trump’s presidency, given his protectionist rhetoric and threat of sharp import tariff increases. It could harm exports – a large provider of jobs – and economic growth, and thus offset the weaker RMB boost, as the USA is China’s second biggest export market and its biggest trade partner. A trade war risk is in theory mitigated by their economic interconnections and thus also by China’s large capacity for retaliatory actions likely to hurt the US economy (via exports and FDI).

Corporate debt at alarming levels

China’s biggest risks continue to grow. The continued deterioration of heavy corporate debt and banks’ bad loans alter the longstanding perception that China will be able to avoid an economic and financial crisis. The current trend of Chinese growth driven by inefficient credit and increasingly requiring debt to sustain high GDP growth is unsustainable. The stock of corporate debt is huge, around 170% of GDP, and exceeds levels encountered in emerging countries which have suffered a crisis in the past. The pace of debt expansion is even more worrying, with credit growth rates far above GDP growth rates, as its share to GDP has soared by 75% since 2009.

The debt build-up is concentrated in a few sectors largely dominated by the property sector followed by mining, oil & gas, steel and coal. It is predominantly (95%) denominated in RMB, mitigating the risk related to the strong USD (except in overcapacity sectors where the USD share is higher). However, in the context of a slowdown and squeezed corporate profits, higher interest rates would put extra strain on the most indebted companies and lead to more overdue and non-payments. The number of corporate bond defaults is already rising rapidly (since the first one recorded in spring 2014) and shows that the State is slowly becoming more reluctant to grant its implicit guarantee. This is also hitting SOEs that are not systemic. SOEs are the most indebted companies as they benefit from easier access to bank financing.

The key question is whether the debt trend is about to reverse. Based on this year’s political agenda, one can hardly hope for anything more than mere moderation in credit growth. Beijing is aware of the debt time bomb but keeps delaying the economy’s deleveraging process. Some measures have been taken, such as debt-to-equity swaps, wiping out hundreds of identified zombie companies and launching mergers and acquisitions in the steel and coal sectors. The former, however, could just be a transfer of risks from SOEs to banks (and savers) as the underlying risk is not tackled.

Deleveraging is a long way off. At the moment, the government has no comprehensive debt-reduction strategy demanding enhanced financial discipline from companies. Vested interests and stability concerns explain the insufficient commitment to China’s most crucial reforms. They also hinder the restructuring of SOEs, despite Beijing’s commitment to a more active market role.

A banking and financial crisis on the cards

The debt spiral, translated into abundant low-quality bank assets, threatens to trigger a banking and financial crisis if there is no decisive corrective action. In this scenario, companies and banks (and numerous non-banking players) would be hit, negatively spilling over to economic activity beyond 2017. The deterioration of the banking sector’s health is reflected by falling profits and a rising NPL ratio estimated at 15% (although the official figure is less than 2%). Moreover, risks may be underestimated because of the lack of transparency and the extent of shadow banking (around 15% of total credit and close to 50% of GDP). Debt-for-equity swaps may reduce the NPLs on the banks’ books but will not necessarily improve their long-term financial situation. Besides, the banks’ increasing use of funding from other banks and lending institutions to offset the downward trend in bank deposits is an additional source of concern.

Looking ahead, small local banks are the most vulnerable entities as they have a much lower deposit base and the highest share of bad loans fuelled by strong credit growth. In comparison, medium-sized and large state-owned commercial banks (SOCBs) look stronger and should be recapitalised at some point in the coming year(s).

Beijing’s financial power to withstand domestic shocks 

Increasing corporate and banking risks are mitigated by China’s high household savings, strong net international creditor position and low central government debt. The fact that the CCP still controls many economic players through a broad network of SOEs and SOCBs is an advantage too. Allowing (non-systemic) financially unsustainable companies to go bankrupt, cleaning up over-indebted SOEs’ balance sheets, recapitalising the world’s largest banking sector (at least systemic SOCBs) and strengthening the supervision and regulation of shadow banking are all actions that have been called for to improve the economy’s health and put it on a more sustainable footing. The longer Beijing refuses lower economic growth, the less effective existing buffers will be and the more postponing the necessary reforms will weigh on MLT growth potential. It remains to be seen whether an acceleration of reforms can be expected during Xi’s politically stronger second mandate and imitate the restructuring process from 15-20 years ago. Meanwhile, state bailouts will gradually decrease, hitting companies in overcapacity sectors such as coal, steel or shipbuilding first of all.

Compared to corporate debt, public debt is much more moderate. Thanks to a favourable budget situation and low debt (at 15% of GDP), China’s central government has room for manoeuvre to use fiscal stimuli.

Hence, the country’s budget deficit widened to 3% of GDP last year – which is also roughly forecast in the coming years – whereas general government debt is on an upward trajectory, rising from less than 40% of GDP in 2014 to an expected 50% this year. This trend will continue as the State supports a slowing economy and faces high contingent liabilities (SOCBs, SOEs) for the central government. However, a larger share comes from local governments, whose debt is still growing as they continue to issue off-budget bonds alongside the bond swap initiative launched in 2015.

A low external financial risk

China has low and sustainable external debt, thereby confirming that its debt problem is primarily of a domestic nature. It has even decreased since 2015, from 16.8% of GDP in 2014 to an expected 10.2% of GDP in 2016. The contraction, largely of short-term liabilities, is explained by accelerated overseas debt repayments, as the RMB is on a depreciating trend against the USD. In future, external debt is forecast to stabilise before progressively increasing in the MLT.

In spite of a high short-term external debt burden, accounting for 78% of total external debt in mid-2016, external liquidity is very strong. Indeed, China has the world’s biggest foreign exchange reserves, covering around 16 months of imports (down from 19 months in 2013) and 3.5 times the short-term external debt. Nevertheless, reserves have dropped, for the first time since 1992, by 21% in 2015/16 as a result of net capital outflows and the PBC’s interventions to limit the RMB’s decline. Reserves have just slid under the symbolic USD 3 trillion threshold, i.e. a six-year low, and should continue on their downward trend in the medium term on the back of capital outflows and the narrowing of the current account surplus.

However, the decline should be much mitigated by determined actions by the Chinese authorities to adjust their strategy to save reserves. They have several options in the pipeline such as a more flexible exchange rate, higher interest rates and extra capital controls.