Friday, 27 December 2019

China 2020: Trade Risks Become Debt Risks

With trade risks receding, keeping China’s rickety financial system on the rails will dominate 2020

Trouble BrewingChinese state-controlled industrial company returns andweighted average bank loan ratesSource: CEIC*Last 12 months.
%Generalloan rateReturn onassets*2008’10’12’14’16’1823456789General loan ratexDec. 2007x7.89%
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China’s terrible, no good, very bad year is finally drawing to a close. Next year is set to start off better, but there are some nasty icebergs lurking beneath apparently calmer waters.
Investors could find opportunities in trade-exposed equities, like Foxconn. But the risk of serious financial turbulence, which they barely avoided in 2019, is rising.
Though most investors didn’t notice, key sections of China’s economy were already on the mend by late 2019, particularly the auto sector—which was mired in a deep downturn for most of 2018 and 2019—and the electronics industry. Auto output rose on the year in November for the first time since June 2018. And electronics makers’ profits have also rebounded strongly in recent months as global smartphone and semiconductor sales have begun to rise again.
In addition, the trade detente with the U.S. reached this month should help ensure some the healing of the labor market, already under way thanks to the electronics rebound.
In two other key parts of the economy, things look far less rosy. Real estate profit growth is slowing rapidly—along with the housing market itself. That, in turn, is putting pressure on state-owned industrial companies, which are concentrated in construction-dependent sectors like steel. Real estate and government-owned industry, along with infrastructure, also happen to be the sectors where China’s debt burden is heaviest.
Foreign investors were spooked by rolling private-sector bond defaults in 2019. But because private Chinese firms make up a small percentage of corporate bond debt—only about 10%—wider damage to China’s debt markets was averted. That could change in 2020. Return on assets for state-controlled industrial companies was just 3.7% in the 12 months to October, the weakest since 2016—and far below average banking lending rates of nearly 6%.
At the same time, heavily indebted property developers, squeezed by the continuing crackdown on shadow banking, have become highly dependent on “preselling” houses before they are built. As the property market cools, that source of funding could start to dry up.
The Beijing skyline. Real estate profit growth is slowing rapidly—along with the housing market itself. PHOTO: GREGOR FISCHER/ZUMA PRESS
Beijing has managed to fight the U.S. to a draw in the trade dispute. The main risk for 2020 is that it declares “mission accomplished” and fails to act aggressively enough to ensure that weakened state industrial firms, local governments, and property developers can refinance their debts at reasonable rates. Compared with past easing cycles, average bank lending rates have barely fallen and credit growth has begun to falter again.
Weakening returns in the most indebted parts of the economy also come as many small banks, which are dependent on borrowing from their larger peers, face capital shortfalls and questions on their solvency. If interbank creditors also start questioning the value of their corporate bonds as collateral—as happened this summer following the state takeover of Baoshang Bank—small banks’ short-term borrowing costs could rise quickly, and some might find themselves unable to borrow at all without central bank help.
On the whole, 2020 seems likely to be a better year for China’s suffering, but highly competitive exporters. It could be a worse year for the ugly, indebted parts of the economy. And many small private companies, despite stabilizing demand for their products, are still struggling with high borrowing costs.
If this year was dominated by trade, next year will be about keeping China’s rickety financial system on the rails.
Write to Nathaniel Taplin at nathaniel.taplin@wsj.com

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