China, Credit Growth And Diminishing Returns

When it comes to (loud) calls for central banks to embark on a coordinated effort to reflate the global economy amid mounting evidence to support the “synchronous slowdown” narrative, there are two potential problems with the notion that monetary policy can ride to the rescue.

The first revolves around the idea that developed market policymakers are constrained in their capacity to respond by i) rates that are at “best” barely off the lower bound and at “worst” still mired in NIRP, and ii) balance sheets that are still bloated.

In theory, policymakers can plunge further down the accommodation rabbit hole, but in practice, that might be difficult. For instance, recall the following chart from BofAML which shows (and I’m quoting a note out last week here) “where interest rates would be if central banks repeated their post-Lehman easing cycle, from today.”

(BofAML)

For his part, BofAML’s Barnaby Martin described some of those red diamonds as “far out of the realms of possibility [as] Hungarian interest rates would drop to -10%, Eurozone deposit rates would fall to -4% and US interest rates would be heavily in negative territory [at] -2.5%.”

But as we noted a couple of weeks back, it might not be entirely accurate to say those numbers are impossible or even far-fetched given the world we currently live in and considering some of the “radical” ideas about money and debt that are floating around out there.

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The second problem pertains to the diminishing returns on Chinese credit creation. While a coordinated reflation push from developed market central banks would be a welcome development, the engine of global credit creation and, relatedly, growth, is China. So, markets are to a certain extent hanging their hats on the notion that a “kitchen sink” stimulus effort is in the cards from Beijing.

While Chinese officials have been careful to suggest that the various easing measures they’ve rolled out over the past year do not constitute an across-the-board, panicked stimulus push, there are signs that Beijing is moving in that direction as the economy continues to decelerate. For evidence of that, look no further than January’s credit data which showed China unleashing a 4.64 trillion yuan tidal wave of liquidity.

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Some of that is seasonal, but the message is clear: Beijing is concerned and the fact that multiple RRR cuts and various other easing levers aren’t yet translating into the kind of real economic outcomes that would indicate things have definitively “troughed” suggests the policy transmission channel is still “clogged”, an issue we (and plenty of others) have discussed ad nauseam.

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One problem is simply that demand for credit appears to be impaired by the prevailing economic backdrop and uncertainty about the future (with the trade tensions obviously serving to cloud the outlook).

But in addition to that, there are three factors that are conspiring to dampen the effect of credit creation. These are laid out succinctly in a new note from BNP that, while not particularly profound, is well worth a read from a kind of “handy pocket guide”/”Cliffs Notes” perspective.

By way of framing things, here is the problem, in two simple charts:

(BNP)

Colloquially speaking, it just ain’t as effective as it used to be.

Why? Well, for one thing, there’s just too much damn debt, so at this point, all that leverage is contributing to a situation where, to quote BNP, “a growing portion of the rise in credit simply serves interest payments.” To wit:

According to the IMF, China’s debt-to-GDP ratio stood at 255.4% in 2018. Assuming borrowing costs at 6% on average, interest payments were equivalent to 15.3% of GDP. In contrast, in 2008 when the leverage ratio was 150%, interest payments represented only 9% of GDP. In other words, more and more new credit was required simply to pay interest without creating any GDP.

That’s clearly no good. In fact, it’s the opposite of good. It’s laughably bad.

In addition to that, BNP notes that the increasing share of investment in property and infrastructure (as a piece of the “new credit pie”) has also perpetuated the disconnect between the credit impulse and GDP growth.

“With a rapid rise in property prices, more credit is needed to purchase the same sized home, but property purchases do not generate much GDP, as they only create property-sales-related services”, the bank chides, adding that “the prosperity of these two sectors have pushed up overall leverage in the economy, but contributed little to value-added GDP growth.”

Finally, BNP cites the infamous shadow banking end-around, where folks were using credit to speculation through the country’s labyrinthine system of back-alley investment products. “Under the disguise of a complex structure of some shadow banking products, loans were used for investment in the stock market or simply for financial arbitrage”, they remind you.

Of course Beijing is working hard to squeeze leverage out of the shadow banking complex, and one of the challenges inherent in that effort is doing it without accidentally triggering an unwind somewhere (because nobody knows where all that credit ended up or, more to the point, what it ended up financing) and without choking off credit to the real economy.

The overarching point in all of this is simply to emphasize that both developed market central banks and China are constrained in their ability to engineer another credit-fueled boom. That’s worrisome if you believe we live in a world where the only way for the system to survive is if we still have the ability to create a new bubble large enough to subsume the previous one.

(Deutsche Bank)