China’s economy shows symptoms of a ‘balance sheet recession’, which can destroy wealth and confidence, force economic agents to cut spending, and create a debt deflation spiral and prolonged stagnation. So should investors worry?
Unlike a recession caused by business cycle fluctuations or macroeconomic policy tightening, a ‘balance sheet recession’ can result from sky-high private sector debt forcing individuals and companies to focus on debt reduction by cutting spending and investment.
Talk of China falling into a ‘balance sheet recession’ has emerged recently as the economy’s post-Covid recovery has lost momentum and ‘animal spirits’ have failed to re-emerge.
Notably, the resulting drop in confidence has caused private sector investment to decline steadily (see Exhibit 1). This deprives the economy of a growth driver, forcing economic agents to cut spending and minimise debt.
The curse of debt deflation
The bursting of an asset bubble and the resultant destruction of wealth leaves the private sector and financial institutions with impaired balance sheets. Typically the private sector responds by cutting borrowing and financial institutions by reducing lending, thus causing a credit implosion.
Unless external demand comes to rescue or there is massive fiscal stimulus, private income falls, pushing up the debt-to-income ratio – the debt burden. This can aggravate the debt reduction efforts and create a vicious debt-deflation cycle.
Financial engineering backfires
Financial engineering adds to the problem. In a highly indebted economy, it transforms debt into investment products sold to the public. Many players borrow to engage in asset churning. These transactions inflate the value of the asset side of the balance sheet, encouraging players to borrow more to fund those transactions and inflating the asset values further. An asset bubble arises.
When the bubble bursts, the debt-fuelled assets deflate, while the value of the liability side of the economy’s balance sheet remains unchanged – at least initially. As companies go bust, the liability side deflates too.
While much of this financial engineering is absent in China, it does exhibit some classic symptoms of a ‘balance sheet recession’, including high debt, a loss of confidence, a poor property market, high risk aversion cutting consumption and bank lending, and (pressure for) system-wide deleveraging.
Debt risk is manageable
While China has a high debt ratio (see Exhibit 2), it has persistently defied predictions of it falling into a debt-currency crisis because its debt is self-funded, its capital account is relatively closed, and Beijing is pursuing a selective ‘implicit guarantee’ policy to uphold systemic confidence.
This combination makes China’s debt a manageable risk, especially when we consider the asset side of its economic balance sheet and financial innovation.
Wealth destruction contained
There is a limited wealth effect from stock investments on private sector spending. Estimates of the share of stock investments in Chinese household’s financial assets range between just 20% and 30%. About three quarters of household wealth is held in property. The decline in housing prices throughout the pandemic was contained thanks to Beijing’s supportive measures including lending restrictions and relatively high minimum levels for down-payments on homes.
Mortgage loans account for only about 20% of total bank loans, so few residential mortgage loans are in negative equity.
China’s immature credit system and limited financial innovation have also kept many high-risk buyers from entering the property market. Thus, we believe it is unlikely for China to experience a US-style subprime housing crash that would lead to massive wealth destruction.
Crucially, China has persevered with its debt-reduction resolve through tough times, despite the trade war with the US and the Covid crisis. This sets China apart from countries whose governments left it too late to act on the debt problem.
Policy lever and growth sources
Aware that the property market’s woes could push China into a ‘balance sheet recession’, Beijing has started to provide more short-term measures to support the economy and the real estate market.
As to the lack of growth sources, China’s ‘dual circulation’ development strategy, implemented since 2020, targets new resources for sustaining long-term growth such as supply chain security, high-value manufacturing, high-tech development and new infrastructure. This includes inter-city railways, research and development on energy and environmental technology, 5G/6G networks, artificial intelligence and the Internet of Things.
The policy is reviving the industrial migration to the interior provinces where untapped and cheaper resources are available, with high value-added industries leading the way.
If China gets this development strategy right, it could make the economy more productive and create sustainable growth momentum, making a ‘balance sheet recession’ only a remote possibility.
We believe investors should reassess China’s growth outlook based on the new direction of its structural reforms rather than dwelling on its past problems.