“You can’t run from them, you can’t cheat them, you can’t sway them with excuses. If you owe them money and you don’t want to crumble yourself, you pay it back.”
~Tywin Lannister (Game of Thrones)
A cheap attention-grabbing title, right? Nineteen million viewers cannot be wrong.
More important, this article’s title is perhaps an apt description of a troubling topic for investors: rising debt. The current expansion of the global economy is now entering its 11th year, but it’s an expansion seemingly built on a foundation of increasing debt balances. In the past, we have raised concerns about the potential excesses in the debt market threatening the expansion, and this remains a concern in our outlook today.
Debt financing is usually plentiful when the economy is strong. Some would argue that is the likeliest time in the cycle for mistakes, and when they are the most consequential. Inevitably, debt balances find their level when economic conditions worsen. Instability and drawdowns often ensue.
This piece looks at debt financing and credit conditions through a specific lens: China. It is an important topic for global fixed income investors today, not only due to China’s size and importance in the global economy, but also because it is a large and growing debt issuer following its recent inclusion in the Bloomberg Barclays Global Aggregate Bond Index.
Interesting commentary in this regard was recently heard across our investment platform at MFS. Members of our financials team circulated their thoughts about credit conditions and the investment outlook for China, prompting great dialogue.
Obviously, China is a large country with a complex economy, and there are many nuances and challenges for analysts. While our views may be skewed by factors unique to a company or region or by an analyst’s particular vantage point, these views are useful in helping us build a narrative for investment consideration.
Overall, the tone of our discussions could be described as subdued, maybe even pessimistic. The economy this year is not as strong as it was in 2018 and is certainly on a downward trajectory from recent peaks in 2017.
The downbeat tone persists even in the face of newly implemented accommodative monetary and fiscal policy. This is not surprising given recent macroeconomic data coming out of China, now worsened by the impact of trade and tariff rhetoric. Uncertainty appears to have taken root, and this will present a challenge for future investment initiatives.
It is noteworthy that China appears to be facing similar challenges to its large, developed market peers such as the United States and a significant number of European economies. Domestic demand is slower and its economy seems less responsive to stimulus.
Money is flowing to equity and property markets while weakening loan demand and expectations of slower economic and wage growth are causing people to anticipate the next stimulus measure. All these economies have struggled to maintain stable economic growth in the absence of significant and accommodative monetary and fiscal policy; we know these stimulus measures are limited.
In addition, as the title suggests, debt balances and credit investment practices are key to economic growth in China, as reported frequently in the press. However, unlike their global peers, investors in China need to look beyond the central government for answers to this potential problem and examine local government debt (local government financing vehicles, or LGFVs), the shadow banking sector (wealth management products, or WMPs) and lending to small and medium-sized enterprises (SMEs).
In each of these examples, debt balances have grown considerably over the past decade, supporting both economic growth and technological and societal aspirations.
Make no mistake: Regardless of the name of the instrument, the issuing entity or the underlying owners of these quasi-assets, this is debt. WMPs, for example, are packaged investment products, risky because of the loans in the structure but cherished for their yield. LDFV debt, on the other hand, is fiscal stimulus issued by a policy institution, sourced, underwritten and accounted for in a manner not always consistent with global peers.
In these structures, low-quality debt is often repackaged, delaying recognition and compounding credit problems. In other words, a rolling loan gathers no loss. Collateral is also valued, but often at the expense of underwritten cash flow. Collateral-backed loans, however, trigger “margin” calls for additional collateral when valuation falls.
This can intensify credit cycles, especially in an economy such as China’s that arguably has not yet experienced a downturn or true capital impairment. Finally, standardized bankruptcy proceedings are still in the early stages of development in China, often making the ultimate resolution of problem debt challenging.
To conclude, I recognize that to say “winter is coming” would make me just another voice raising the alarm over China’s debt balances. The country undoubtedly has many levers available within the ambit of its economic and policy structures to address issues like this. Recent attempts to rein in the shadow banking system and increase transparency at the LGFV level exemplify this point.
However, all things being equal, slower economic growth is likely to result from these efforts, and more so if the trade and tariff tensions between China and the US remain unresolved for some time.
Instead, my aim is to draw attention to the increasing complexities in this large economy, as well as to the elements of its credit and investment culture that differ from its global peers. Investors outside China must be aware of the country’s particular nuances to understand the risks and the opportunities to be found in China’s unique economy — and the resources required to do this.
Active investment managers need to understand investments from the bottom up, fully cognizant of the risks described here, while also staying on the constant lookout for opportunities. Additionally, investors must understand the risks inherent in large passive exposures to China as its stocks and bonds continue to enter global indices in considerable size.
William J. Adams is chief investment officer, global fixed income, MFS Investment Management.
