When A "Black Swan" Will No Longer Do: China Warns Beware The "Gray Rhino"

Early this morning, we discussed the unexpected tumble in the Chinese small-cap stock index, the ChiNext, will plunged by over 5%...

... as a result of growing concerns that a new round of deleveraging is about to be imposed by Beijing following the conclusion of China’s 5th National Financial Work Conference (NFWC), which was attended by president Xi Jinping, and set the agenda for critical financial reforms over the coming years. As the People's Daily noted on Monday:

The meeting, presided over by President Xi Jinping, was held against the backdrop of growing enterprise debt, an overheating real estate market, and overcapacity in such sectors as low-end manufacturing.

Furthermore, the commentary touched on the recent OECD finding that the debt of non-financial enterprises in China reached 170% of its GDP in 2016, and warned that "in its 2017 China Financial Stability Report released early this month, China's central bank, People's Bank of China, pointed to "the risk of bubbles" emerging in some parts of the country. The report notes that housing loans comprised a quarter of all loans, and accounted for 44.8% of all new lending since the start of this year."

Perhaps the biggest outcome from the weekend Conference was the creation of a financial "super-regultor" meant to tackle the growing threat of a financial crisis, and among its broad conclusions were  i) To make finance better serve the real economy; ii) To contain financial risks; and iii) To deepen financial reforms. The proposed reforms are the result of the unprecedented increase in overall Chinese debt, which while promoting growth - in this case China's latest 6.9% GDP print - is also leading to a relentless buildup of risks. And while until now Chinese regulators had homed in on financial-sector excesses, the latest probe - Bloomberg notes - is now widening to debt in the broader economy, "a shift that prompted a sell-off in domestic stocks."

There was another reason for the market's swoon. Earlier on Monday China People’s Daily newspaper warned of potential "gray rhinos" which it defined as "highly probable, high-impact threats that people should see coming, but often don’t."

So in a surprising case of forward-looking prudence, the Chinese government is doing what numerous Fed members have also done in recent weeks, by setting a surprisingly wary tone about risk, demonstrated best by the front page commentary in the People’s Daily, which said China should not only be alert to "black swan" risks that catch people off guard but also more obvious threats, citing cited a term popularized by author Michele Wucker’s book "The Gray Rhino: How to Recognize and Act on the Obvious Dangers We Ignore."

Noting that with the economy still on a slowing-growth trend, the People's Daily commentary said that China should "strictly prevent risks from liquidity, credit, shadow banking and abnormal capital market fluctuations, as well as insurance market and property bubbles." And, as Bloomberg adds, the new focus on "deleveraging in the economy" suggests that local-government and state-owned enterprise debt is now very much in the spotlight. In other words, this time Beijing's crackdown on excess debt may actually be real.

of course, by now it is widely understood that China’s strong (credit-driven) momentum has fueled global economic expansion and boosted sentiment in international markets, and served as the springboard for the global economic rebound in the depths of the financial crisis (when China's debt load was roughly half the current one).

The nation’s solid growth reinforces recoveries for commodity exporters and keeps 2017’s pickup in global growth on track, said William Adams, senior international economist at PNC Financial Services Group in Pittsburgh. However, this too is now ending, as we have repeatedly demonstrated courtesy of China's Credit Impulse, most recently one month ago when we showed that according to UBS, the global credit impulse has tumbled as a result of China's push to delever.

It is also worth noting, that while China has previously repeatedly stated its intention to delever - unsuccessfully on every single occasion - this time it appears to be doing just that, if only in partial terms: we showed as much last week when we showed the ongoing sharp contraction in China's shadow banking sector, offset however by a surge in local loan creation.

To be sure, pundits are applauding the PBOC's prudent approach.

The strong data suggest across-the-board robustness in the industrial sector in June, said Zhu Haibin, chief China economist at JPMorgan Chase & Co. in Hong Kong. China can aim for faster deleveraging in the real economy in the second half and the leverage ratio will come down significantly this year with nominal GDP growing and credit growth slowing, he said.


"It’s a good time for corporates to cut excess leverage, especially for state-owned enterprises," Zhu said. "We’re now in an upward trend of the economy which makes it less painful and much easier to push ahead."

In a separate commentary by China Daily, the official English-language newspaper added that fending off risks is one of the country’s top priorities, with corporate debt running high, the property market being overheated and excess capacity in some sectors lingering, adding that "only through guarding against financial risks can a sound and stable financial sector better fulfill its duty and purpose of serving the real economy."

While it is admirable that China continues to push for deleveraging, it faces an uphill battle, not least of all because as the IIF recently calculated, China's debt is not only the biggest contributor to global debt growth, currently at a record $217 trillion, but as of 2017 is at just over 300% debt/GDP. Meanwhile, the marginal benefit of all this debt continues to shrink, with the Chinese economy growing at levels just shy of all time lows.

Meanwhile, for all the talk of structural reform, virtually nothing has been done: "It’s a cyclical recovery story on strong exports and real estate," said Junheng Li, founder of JL Warren Capital, a China-focused research firm in New York. "Both are the same old growth drivers. Very little supply-side reform and restructuring have been done in the first half."

Going back to Citi's Liu Ligang, he summarized China's dilemma best: "the gray rhinos are containable" but the economy is "still relying quite a lot on investment and credit and overall financial leverage is still building up. There’s no doubt that China’s debt overhang is still a serious challenge."

How China pulls off what has historically been an impossible task of slowing credit creation without sending the economy into a tailspin and crashing its markets, remains a mystery, regardless if one wants to call the ultimate outcome a "black swan" or a "gray rhino."