The rebalancing of China's economy has not so far involved a move away from dependency on rapid credit growth, according to Fitch Ratings.
The ratings agency believes that Chinese policymakers will continue to use strong credit growth to meet near-term GDP targets, which will increase the size of asset-quality problems in the financial system.
China's economy has rebalanced in two meaningful ways in recent years. First, growth in the services sector has outpaced that of the industrial sector since late 2011, and has become a main economic driver. Second, on the expenditure side, consumption has overtaken investment as the largest contributor to real GDP growth.
These shifts, combined with the authorities' intentions to reduce over-capacity in the industrial sector, should facilitate an adjustment towards slower - but more sustainable - growth over the medium term.
Dependent on credit expansion
However, there remains little evidence that the economy is rebalancing in a third, perhaps more important, way - it remains heavily dependent on credit expansion to meet GDP growth targets.
Growth in outstanding renminbi bank loans rose to 13.0% yoy in August, while total social financing growth was up to 12.3%. A larger share of new credit is now going to the household sector, especially in the form of mortgage lending.
Lending to households is generally safer than to the heavily leveraged corporate sector, given that mortgages face tight lending restrictions and household debt is comparatively low. However, there is still an issue - to the extent that it boosts real estate prices further, and corporates then use inflated property prices to secure borrowing of their own.
Fitch has estimated in previous research that NPL rates could already be as high as 15%-21% for the financial system. In contrast, official data showed the NPL ratio for commercial banks was just 1.8% at end-1H16.
There seems a high likelihood that banks' NPL ratios will continue rising over the medium term, in light of this discrepancy. There are already signs of stress, most obviously in the increased frequency with which banks are writing off or offloading loans, such as those to asset-management companies.
“We estimate that a one-off resolution of the debt problem would currently result in a capital shortfall of CNY7.4trn-13.6trn (USD1.1trn-2.1trn) - equivalent to around 11%-20% of GDP,” says Fitch.
Fitch adds that the capital gap could rise by another 10pp-13pp by end-2018 if inefficient credit continues to rise at the same rate as recent years and no additional internal or external capital is raised.
It is unlikely that the credit gap will need to be addressed all at once. Fitch expects risks to be gradually managed through a combination of growth and writing-off, offloading and refinancing more loans.
Banks are likely to be central to any meaningful resolution of the debt overhang, and will probably need to absorb a significant portion of any losses. Mid-tier banks have the weakest buffers, and are the most vulnerable to funding stress. Their Viability Ratings are likely to come under the most pressure if fresh capital is not raised.
“We think that sovereign resources will ultimately be needed to help address China's debt overhang,” says Fitch.
Fitch estimates general government debt to have reached 55% of GDP in 2015 (including around 34% of GDP in local government debt), only slightly above the 52% median among other 'A' rated sovereigns.
Meanwhile, pressure on China's sovereign rating (A+/Stable) could emerge if general government indebtedness were to rise significantly above our current estimates.
An upfront resolution of problem credit and recapitalisation of the financial system is not Fitch's base case, but it is one scenario that could lead to an unexpected increase in general government debt.