Will China Experience a Balance Sheet Recession?

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Recently, many investors have been discussing the balance sheet recession that began in Japan in the early 1990s and are concerned that China’s economy may face a similar situation. But what exactly is a balance sheet recession, and how did it occur in Japan?

The story began with the appreciation of the US dollar (on a trade-weighted basis) by nearly 80% between 1980 and 1985. During this period, the US Federal Reserve raised interest rates to combat inflation, leading to a widening interest rate differential between the US and other industrialized countries. This attracted capital inflows, causing the US dollar to strengthen. To alleviate the economic pressure caused by the stronger dollar, the US government convened a meeting in September 1985, attended by finance ministers and central bank governors from France, the UK, Germany, and Japan. The result was unanimous agreement to systematically assist in the devaluation of the US dollar.

While Japan agreed to help weaken the US dollar, the Japanese government also feared that a stronger yen would negatively impact exports and, consequently, the economy. To counteract this, the Bank of Japan decided to lower interest rates to stimulate consumer demand and offset the effects of the stronger yen. However, the interest rate cuts also stimulated the rise in asset prices.

At that time, it took three generations for an average family to repay a home mortgage. The value of the land of the Imperial Palace in central Tokyo was so high that it could have bought all the properties in Manhattan, New York. The Japanese government began lowering interest rates in the mid-1980s, but it wasn’t until mid-1987 that they realized that property prices were overheating and attempted to control them by raising interest rates. The overnight rate in Japan gradually increased from 3.3% in mid-1987 to 8.3% in March 1991. The continuous rate hikes burst the real estate bubble.

As property prices began to decline, and with the yen exchange rate significantly higher than a few years earlier, many Japanese companies found it increasingly difficult to conduct business. If companies don’t reduce their debt level, the elevated interest rate might send them to bankruptcy. Japan’s corporate debt-to-GDP ratio reached 139% in 1990, significantly higher than the 63% for the US, 96% for France, 60% for Germany, and 58% for the UK. Debt and the economy are intricately linked. When companies and individuals use increased borrowing to invest and consume, it stimulates the economy. However, when both prioritize debt repayment, the funds available for investment and consumption decrease, hampering economic growth. Japan’s per capita GDP remained around 4 million yen from 1992 to 2012, with little to no growth. If not for the government continuously increasing borrowing for investment, Japan’s per capita GDP in 2012 might have even been lower than in 1992.

When property prices and the economy decline, it’s not only companies and individuals that are affected. If property prices fall sharply to the point where assets no longer cover debts, banks also begin to suffer from bad loans. This makes them more cautious and conservative in lending, ultimately slowing down the entire economic system.

So, will China experience a balance sheet recession?

There are significant differences in economic structures between China and Japan. From the corporate debt level perspective, as of 2021, the corporate debt to GDP ratio in China is approximately 131%, ranking second compared with G7 countries, which is relatively high. However, according to a 2022 S&P research report, about 75% of corporate debt in China belongs to state-owned enterprises. If state-owned enterprise debt is treated as government debt, the non-state-owned enterprise debt ratio to GDP is only 31%, lower than all G7 countries.

These calculations don’t mean that state-owned enterprises won’t face problems. However, if state-owned enterprises encounter debt issues, the government is likely to provide full assistance, and the chances of state-owned enterprises defaulting or deleveraging are relatively low. Of course, in the long run, for state-owned enterprises to develop healthily, they need to improve their operational efficiency and ultimately approach the level of private enterprises. If state-owned enterprises’ operating cash flow is insufficient to repay debt over the long term, and debt continues to accumulate, they could become zombie enterprises, leading to a continuous rise in national debt and a decline in economic efficiency.

As for personal debt, although personal debt in Japan decreased slightly from 1990 to 2010, the reduction was marginal compared to corporate debt. The ratio of personal debt to GDP only decreased from 68% to 61%. In the US, the ratio of personal debt to GDP reached 99% before the global financial crisis in 2007, then gradually declined to a low of 75% in 2019. In China, the ratio of personal debt to GDP at the end of 2021 was 62%, slightly lower than Japan before its balance sheet recession and significantly lower than the US before the global financial crisis.

From this perspective, the scale of corporate and personal debt in China is smaller than that of Japan and the US before they experienced economic crises. Additionally, China’s banking system is largely state-controlled, so as long as the government relaxes monetary policies, it’s unlikely that banks will be unwilling to lend. Therefore, despite the current fragile economic atmosphere in China, we believe that the government has the capability to prevent a balance sheet recession from occurring.

Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.

In respect of any discrepancy between the English and Chinese version, the English version shall prevail.

Why is the U.S. stock market performing better than expected?

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The two most discussed topics in the market recently are: first, why does it seem like the interest rate hike has little impact on the US economy, and second, why is the US stock market performing much better than expected? Even Wall Street’s leading bearish strategist is doubting himself and changing his tune.

In fact, these two topics are somewhat related, so we will discuss them together. Many people say that the US economy typically slows down 6-12 months after the Fed raises interest rates. However, the Fed kicked off the rate hike last March, while the US economy is still showing no signs of slowing down in the first half of this year, with actual GDP growth of 2% and 2.1% year-on-year in the first and second quarters, respectively. This has surprised many.

It is estimated that the US government injected a large amount of money into the economy during the pandemic to ensure stability, and much of this money is still in banks. So, despite the high interest rates, people still have money to spend and buy stocks, supporting the US economy and stock market. The ratio of bank deposits to GDP in the US was about 64% at the end of April, slightly higher than the 60% that had been maintained for many years before the pandemic but lower than the peak of 77%. At the current pace, it is estimated that bank deposits will not return to pre-pandemic levels until the end of this year, indicating that the impact of the interest rate hike on consumer spending may not be reflected until the end of this year or early next year.

Second, for more than a decade, global interest rates have been kept low for a long time, and many companies have seen that interest rates are approaching zero, so they took the opportunity to convert their debt into fixed-rate long-term bonds. So even though the federal funds rate has increased by 5%, most companies’ interest burdens do not seem to have been greatly affected for the time being. Of course, many small and medium-sized companies may calculate their loans based on floating interest rates, especially those who finance through private credit. However, the lack of transparency makes it difficult to assess risks. If we use the high-yield bond market, which is similar in size to the private credit market, as a reference to gauge, the default rate for US high-yield bonds may rise to 4.5-5% by the end of this year from about 1.9% as of this May, according to data from Fitch Ratings.

Third, although the US government has reduced its fiscal deficit this year compared to the pandemic period, it is still relatively high compared to normal years. Part of the reason is the increase in interest rates, and part is due to President Joe Biden’s $2 trillion investment package, which plans to allocate funds to infrastructure upgrades, inflation reduction, semiconductor production, and research, among other things, over the next ten years. These long-term economic stimulus plans have also contributed to the government’s deficit rate rising.

As a result, when individual consumption, businesses, and the government have not yet truly felt the impact of the interest rate hike, how can the economy slow down?

But what about the future? There are two noteworthy changes. First, as mentioned earlier, there is a possibility that the ratio of bank deposits to GDP will return to pre-pandemic levels by the end of this year. The second change is that student loan repayments, which were put on hold, are set to resume in October this year. Currently, there are 37 million student loan borrowers in the US who have benefited from deferred repayments, with a total monthly repayment of approximately $10 billion. For reference, Americans spend about $35 billion a month on clothing and department stores. While $10 billion may not be a substantial amount, it will impact consumption.

There is a saying in the market that when even the last bear turns bullish, it indicates that the market is not far from its peak. Is Wall Street’s leading bearish strategist, who recently turned bullish, the last one?

Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.

In respect of any discrepancy between the English and Chinese version, the English version shall prevail.