PIMCO, the world’s largest bond manager, has constructed a ‘balance sheet’ of the Chinese financial sector and subjected it to various stress tests. The manager concludes: the situation is manageable but watch out.
In its latest ‘Secular Outlook’ series of client information notes, PIMCO provides what is probably the consensus view of China’s outlook, such as a downshift in growth to 6-7.5 per cent in GDP, reduction in imports of commodities, reduction in domestic investment and increase in domestic consumption.
However, if China is to blow up, in terms of the markets – if it’s been in a credit or real estate bubble and this bursts sometime soon – then it will happen because of domestic credit, as is often the pattern with bubbles.
PIMCO says there has been a massive expansion of credit in China in recent years through the shadow banking system, as we know. This has involved financing in property development and regional and local government infrastructure. The concerns are: the quality of these loans are doubtful and the assumption Beijing will bail them out is just that: an assumption; and the effectiveness of credit growth in generating economic growth is diminishing, which itself increases the risk that borrowers will be unable to repay their loans. The PIMCO researchers estimate that before the global financial crisis, each $1 of new credit generated an average of 60 cents in GDP growth. Now, that number is falling towards 20 cents.
The client note says: “So there are clearly risks, but just how big are the risks? We have analyzed this question by constructing a balance sheet of the entire Chinese financial sector, subjecting it to various “stress test” scenarios – assuming that non-performing loan ratios and the severity of loan losses rise – and measuring the fiscal cost to the government of having to recapitalize the Chinese banking sector in such scenarios.
“Our analysis shows that even under a severe set of assumptions, the costs are manageable at present. But when we make our model dynamic, projecting the future path of such recapitalization costs on the current trajectory, we observe that the potential costs of a banking bailout would rise dramatically in the coming years if the rapid growth of shadow credit continues.
“This underscores the importance of a transition in China’s growth model, away from the continued reliance on credit- fuelled investment and toward household-led domestic demand. The longer the delay in making that transition, the greater the risks of financial stress during the secular horizon.”