China’s January credit frenzy masks debt pressure

by: FT Confidential Research

• Record credit activity in January signals growing credit risk as much as it does increasing confidence in the recovery.
• The People’s Bank of China has begun raising rates in the financial system but is constrained by the risks of putting up borrowing costs too much and pushing companies into default.
• We do not expect this volume of borrowing to continue. Once local government bond sales are up and running for the year, reliance on bank loans will fall.

Another January, another credit blowout. But the month’s record lending activity signals mounting pressure on corporate China to roll over its debt as much as it does confidence in the economy.

The People’s Bank of China is now tightening monetary policy at the margins but is constrained in how far it can go because of the mounting pressures to service outstanding, and growing, debt obligations.

Total social financing, the central bank’s broadest regular measure of system-wide credit activity, rose 7.6 per cent year-on-year to a record Rmb3.74tn ($544bn), equivalent to 5 per cent of 2016 GDP (see chart). This included Rmb2.03tn in net new bank loans, representing a slower pace of growth year-on-year and lower than market rumours in the lead-up to the release, but still the second-biggest monthly haul on record after last January’s Rmb2.5tn.

Even by the standards of the China debt debate, these are big numbers and we certainly do not expect lending to continue like this through the first quarter of 2017, never mind the year. We see a number of factors driving January’s activity:

• Companies may have noted that the central bank has begun raising interest rates in the interbank market and rushed to borrow before these feed into corporate lending rates. After nearly five years of producer price deflation ended in September, companies are regaining confidence and willing to take the government’s lead on infrastructure investment.
• January also reflects increased bank borrowing by local governments, which are waiting for the central government to hand down the year’s bond issuance quota. A substitution effect has been seen between local government bond issuance and medium- and long-term corporate loans since 2015, when Beijing began a programme for local authorities to issue bonds and retire their bank loans (see chart). As with the same month last year, local government bond issuance in January was zero.

• The end of the bond market rally has also driven up demand for bank loans. The record Rmb1.52tn in net new medium to long-term corporate loans — which are thought to be put to economically productive use — represented a 43.4 per cent increase over the same month last year. In contrast, net new corporate bond issuance was net negative for a second straight month, at -Rmb53.9bn against Rmb508.3bn in January 2016.
• Another key driver of medium- and long-term bank loan growth was household borrowing, which rose from Rmb421.7bn in December 2016 (and Rmb478.3bn in January 2016) to Rmb629.3bn in January, also a record high (see chart). Although mortgage lending unexpectedly surged in January, we do not expect this to last. Much of this lending was probably carried over from late 2016 as annual quotas were reset, but the screws are being tightened on the housing market, and this will continue. Housing sales have fallen sharply already, and local governments are continuing to restrict purchases.

Into the shadows

But these data also reveal weakness in the economy. The surge in shadow finance activity at the end of last year has carried on into January, reflecting a crackdown on traditional financing channels for property developers and the end of a bond bull market. Combined net new funding via entrusted loans, which are made between companies, bankers’ acceptances, which are issued between banks on behalf of borrowers, and trust loans hit a record Rmb1.24tn versus Rmb405.4bn last January.

Increased reliance on shadow finance confirms our view that Chinese companies are facing mounting pressure to roll over their existing debt and are resorting to shorter maturities at higher interest rates to do so. Ahead of a key Communist party meeting in late 2017, the authorities may want to keep a close eye on the shadow finance system as they try to maintain stability. However, these latest data suggest default risks are increasing.

A balancing act

The central bank is continuing to tighten monetary policy at the margins in order to bring credit activity under control. Since January, the PBoC has increased the cost of the funds it regularly lends to institutions in the interbank market, covering loans of between seven days and a year (see chart). The intention is to guide up interest rates in the financial system make it more expensive to engage in the kind of speculation that drove bond yields to multiyear lows last year. Higher onshore rates may also help deter capital outflows.

The central bank’s trick will be to discourage investors from taking undue risk with cheap money — “curbing asset bubbles”, in official parlance — while keeping economic growth on an even keel. That is why the rate increases so far have been low-key and moderate; the price of borrowing from the bank’s medium-term lending facility rose just 10 basis points. These moves are unlikely to discourage indebted companies from continuing to borrow, banks from continuing to lend — and local governments from encouraging these relationships — if the alternative is default.

The PBoC still publishes the deposit and lending rates that acted as market benchmarks before deregulation in 2015. Although the banking system is no longer bound to follow them, adjustments to these rates would send powerful signals to the market because they are still used as a guide for pricing deposits and loans.

We never rule out surprises in Chinese monetary policy decision-making, but also believe there is no need to resort to this policy tool immediately. January’s higher inflation readings than expected may have given a scare, but we expect price pressures to cool in the months after the lunar new year holiday and as the property cycle continues to turn down.