The underlying issue plaguing China’s economy is the misallocation of capital. “If you look at Chinese banks’ balance sheets, the assets are increasing, but the earnings are not,” Mulhern told FSA. “This tells you that the quality of those assets [loans] is deteriorating.”
In 2015, China was able to respond to the effects of financial stress in 2015 with fiscal stimulus, which reflated state-owned enterprises, he said. In addition, globally there was a favourable market environment due to quantitative easing by the Bank of Japan and the European Central Bank.
However, as central banks wind down QE policies, mitigating the effects of an economic slow-down won’t be as easy.
Mulhern sees a repeat of 2015. “In many parts of China’s economy you had a recession in 2015,” he said. “I don’t think anything has changed since then, [in macro-economic and structural terms].”
China’s economy is suffering from excess of credit and a high share of non-performing loans, he said. “The size of the credit bubble in China is on par with those that are synonymous with financial and economic stress,” he said.
Chinese authorities face the classic conundrum of “impossible trinity”, Mulhern said. “You cannot control your currency, your interest rate and your money supply.”
Government-backed banks?
One can argue that much of bank debt in China is in effect backed by the government. It can be absorbed in the government’s balance sheet, which then can do away with the non-performing loans issue through printing money.
This won’t however, put China’s economy into clear waters. “China’s monetary system is effectively beholden to what’s going on with the Federal Reserve, because they have effectively pegged their currency to the US dollar,” he said. If the dollar strengthens, that puts financial stress on the country’s balance sheet.
China embarked on a massive quantitative easing in 2016 through a debt-for-equity swap. “They were able to do that because the dollar was weak and they were able to [implement] capital controls,” Mulhern said.
The vulnerabilities have not been resolved, however, he argues. “There’s still a lot of dollar debt exposure in China and if you have a downturn in the global economy, then the external balance sheet of China will start to deteriorate and those vulnerabilities will resurface again.”
Efforts to recapitalise banks would involve printing money, which would lead to devaluation of the renminbi and capital outflows. While there’s been a perception that this has been so far averted by capital controls, “people have not wanted to get their money out of China” due to the synchronised global economic upturn, Mulhern noted. If the global economy enters a downturn, the outflow pressure will resurface.
This is not an issue when the global economy is growing, but Mulhern is convinced a significant correction is coming.
“Leading indicators already tell me that China is going to continue to slow down into the year end.”
Unless the country implements a stimulus, markets that are closely linked to Chinese economy, such as commodity-driven Brazil, Russia and Australia will slow down as well.
While the developed markets of Europe and North America still show a growth momentum, they won’t be able to decouple and will slow down, too, he said.
“The underlying structural issues that beset the world economy have not been resolved,” he said. “The excess of credit has only got larger – there’s a talk of deleveraging, but it’s all just nonsense. There has been no substantial deleveraging, we’ve just had a shift of locus of credit.”
