by Alex Cousley, Russell Investments
A number of high-profile Chinese state-owned enterprises defaulted in November 2020, notably Yongcheng Coal and Electricity Holding Group, Tsinghua Unigroup and Huachen Automotive Group. There has been concern around the level of Chinese debt for a long time now, and 2020 saw even more debt added to the system. Importantly, however, we think that these defaults need to be considered in the context of a financial system that is maturing and opening—in addition to the economic recovery taking place. Ultimately, we do not think the recent string of defaults poses a systemic risk to China.
China 2021 growth outlook
Before we dive into the reasons why, let’s back up a bit and take a look at the broader outlook for China this year. Above all, we expect the Chinese economy to experience a solid year of growth. The International Monetary Fund (IMF) is currently forecasting 7.9% real GDP (gross domestic product) growth in 20211—well above trend growth. This should flow on to the rest of Asia, given how interrelated Asian trade is. Fiscal policy will also remain supportive, and we expect to see more targeted measures to boost household consumption at the March National People’s Congress.
On the other hand, we continue to think that monetary policy is going to become less accommodative. Importantly, we’re seeing early signs that the upswing in the credit cycle is now easing.
On an international level, while risks around China’s relationship with the U.S. remain, our baseline expectation for now is that tensions between the two nations should ease a little bit this year—which should be a positive. It’s important to note, however, that we don’t foresee a return to the pre-Trump era of China-U.S. diplomacy—which means there will still likely be several secular issues that will be difficult to resolve.
Is market concern over the recent defaults warranted?
Let’s turn our attention now to the recent string of high-profile defaults among state-owned Chinese enterprises. To us, the events feel very similar to the events of 2019, where we saw defaults amongst Chinese banks. At the time, we stated that we thought the risks around Chinese debt were overblown. We continue to think that, in the near term, this is still the case. In fact, when viewed through the lens of the market maturing and becoming more open to overseas capital, these defaults are actually positive in a way. Why? Because they show that the Chinese government is keen to exert a bit more capital discipline (rather than simply bailing out businesses whenever they land themselves in distress).
However, the recent defaults have made some investors understandably nervous, given that Chinese bonds are now being included in passive indices. Here, it’s important to distinguish between the corporate debt market and the government/policy bank debt market. Specifically, the flows that will be directed to China through the inclusion of indices are going to government bonds and policy banks—not to the corporate debt market. Therefore, the recent defaults are not a harbinger of risk for those flows.
3 potential implications of recent defaults
So, what are the potential implications of these defaults? We believe that there are three in particular.
The first is that this could be the canary in the coalmine of significant strain in the Chinese financial system. However, we don’t think this is likely at all, given the solid economic growth over the past six months and the growth expectations for this year. While China’s elevated debt levels (the current debt-to-GDP ratio stands at a level above 340%) make this something always worth considering, we ultimately believe that the risks around this are quite low at the moment.
The second implication—one we are watching closely—is the extent to which these defaults impact the risk-taking behavior of Chinese banks. This applies, in particular, to the lending to local government financing vehicles. Chinese banks typically assign an annual lending quota to provinces and cities (i.e., the local government financing vehicle), which makes this something to pay attention to. In other words, will Chinese banks adjust their lending quotas in light of the recent defaults?
The final consideration is whether this leads to a dampening in the demand for Chinese, and for that matter broader EM, assets. It is still early days given these defaults happened two months ago, but we have seen continued inflows into EM equities and bonds.
The bottom line: Maintain focus on the cycle for EM and China
In summary, while recent headlines around the defaults were eye-catching, we don’t think they’re an ominous sign for the outlook for China—or, on a broader scale, emerging markets (EM). We continue to believe that the outlook for EM (and China) over the next 12 months still looks positive, given the context of an early cycle recovery, albeit with the credit cycle in China set to slow. While EM equity valuations do look a bit expensive—as is the case in many equity regions right now—we expect that the positives of early cycle growth will outweigh this in the shorter term.
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