China puts handbrake on debt

7 September 2018

China’s appetite for debt drove post GFC growth. Mark Rider explores what this means for markets.


The world’s second biggest economy built up huge amounts of debt after the global financial crises, with growth peaking at 30 per cent in 2009.

This rapid credit growth helped prop up post-GFC growth and supported investment markets.

But China’s government has acknowledged the earlier pace of credit growth was unsustainable. After undertaking another economic stimulus program in 2015, that pushed credit growth to over 20 per cent, credit growth has now more than halved to 8 per cent.

China leveraged up post GFC

Credit growth leapt to an annual pace of over 30 per cent in 2009, providing a huge boost to the economy, as shown in the graph below.

While the pace of growth has slowed since then, it has still outpaced the growth rate of the economy.

China share as a percentage of GDP

As a result, the stock of debt has doubled to a little under 250 per cent of GDP, as shown in the graph below.

What this means for markets

Such dramatic swings in credit grown will inevitably be important for the economy and markets. The best way to look at this is to see how much the growth of credit changes, rather than simply the pace of growth. This is commonly referred to as a ‘credit impulse’ measure. China’s credit impulse is a measure of its changing growth of credit, relative to the size of its economy.

When you factor in a year’s lead time, China’s credit impulse shows a distinct correlation with returns from global equities over the last decade as indicated below.

China credit impulse and percentage of global equity returns

Given the close link with economic growth trends, it’s not surprising that there is a correlation between the credit impulse and the returns of global equities with the lead of a year. The moderation in equity returns so far this year is consistent with a trend towards a fading credit impulse. There’s also been a sharp weakening in the credit impulse in recent times, which can’t be ignored.

The current reading puts the credit impulse at its weakest in a decade but with some signs of stabilisation beginning to emerge. However, credit leads the economy by around a year and flags a weakening in momentum for a while yet. But the impact appears to extend well beyond China’s shores.

The global impact

The China credit impulse, with a lead of around a year, has correlated reasonable well with the Global Manufacturing Purchasing Managers Index (PMI).

In a world where most economies were reducing their debt burden, China’s aggressive leveraging has stimulated growth. The relationship is particularly evident for trading nations such as Germany in the well-known IFO sentiment survey for the German industry.

It warns a sharp slowdown in global manufacturing may eventuate if China’s weak credit impulse is maintained for a period of time. Fortunately China has undertaken a range of easing measures in recent months, with some recovery underway but it is still early days.

The two largest economies – the United States and China – are both implementing policy settings pointing to a slower economy. An economic slowdown and weaker investment returns in 2019 look highly likely. The US’s large tax cuts and increased government spending may hold up US growth for longer than expected. And limited further tightening for the US Federal Reserve would point to only a moderate slowdown in growth. Just how severe this slowdown will be is unclear.

For China, there’s been a sharp weakening in the credit impulse which can’t be ignored. The current policy easing underway may limit the downside, but it’s early days.

For the full Investment Spotlight read here.