China: Medium-term challenges remain – Danske Bank

Research Team at Danske Bank, suggests that while China is experiencing a cyclical recovery in the short term, challenges remain in the medium term.

Key Quotes

“May data for fixed asset investment surprised on the downside despite a pick-up in planned projects, suggesting that overcapacity is still weighing on investment activity in many areas.

Another increasing concern in China is the continued rapid build-up of debt. It is not so much the level that is worrying. While 250% of GDP sounds high, this is actually similar to countries such as the US, UK, France and Italy. However, what it worrying is the speed at which the debt keeps rising and that it has happened alongside a sharp downturn in the economy, leaving question marks over where the credit is actually going. China needs to transition to growth and become less dependent on debt and it is unclear how it will pull this off.

Another concern is that non-performing loans will rise sharply and cause a financial crisis. We do not believe the short-term risk of a financial crisis is high as the financial system in China is dominated by big state-owned banks that will not ‘crunch credit’ unless the government allows it. But of course a concern is that adding debt could lead to much higher losses in the future, creating a situation that eventually gets out of control if confidence erodes in the short-term financing channels for the banks and the tap is cut off. The concern over debt is also in itself making companies more cautious, leading to less inflow of productive capital.

The continued rebalancing away from industry-driven growth towards services is another challenge. It requires the closure of zombie companies and a move of labour from inefficient state companies with overcapacity to jobs in the service sector and in high tech industries. This is not a trivial task.

Finally, China continues to struggle with balancing the housing market and avoiding bubbles. On the one hand, China is faced with a significant oversupply of some areas and, on the other, house prices are again shooting up in an uncontrollable way in the big cities with annual increases of 30%. Regional bubbles could spell trouble in the future.”