As China’s leaders scramble to contain the coronavirus epidemic, the global community braces for impact to China’s people, equity and bond markets, and economy—the world’s second largest.
Already, COVID-19 has been the biggest source of volatility for China’s equity markets and has shaken economies around the world. Investors have even raised concerns about Chinese banks’ ability to withstand a possible wave of defaults.
We think fears about market impact and a default wave are overblown. Here’s why.
Turning Point Fast Approaching
We agree that the coronavirus outbreak represents one of the biggest risks to China’s economic growth in 2020. But we believe China’s economy will prove resilient, especially if the epidemic is curbed within the first half of the year. And that seems increasingly likely. The recent exponential jump in the number of confirmed cases conforms with our expectations of a peak—and turning point—in early March.
If the epidemic is indeed controlled before June, we expect China will suffer a one percentage point hit to GDP growth. If we’re wrong, and the contagion persists throughout 2020, that penalty increases to 1.9%.
We believe that the Chinese government still wants to achieve a growth rate of between 5.6% and 6% for real GDP in 2020, in order to double the per capita GDP from the 2010 level. To achieve this rate, we expect China to go beyond aggressively easing monetary policy. We expect to see the fiscal deficit increase in 2020 by 0.5% from the 2019 level, and special local government bond issuance may double to 3.5–4.0 trillion RMB as well.
Lastly, China’s economy tends to have a seasonal pattern, with output lowest in the first quarter and highest in the fourth. It’s therefore likely that China will catch up later in the year, following a sizable hit to first-quarter growth.
China’s Stable Banking System
A stable and liquid financial system is the wellspring of China’s economic vitality. That’s why the world held its breath in 2019 when China resolved three distressed regional banks in rapid order. Today’s epidemic places additional stresses on China’s financial system.
There are two major reasons that we don’t expect these added stresses to translate into a major shock to the banking system. First, Chinese authorities have a track record of taking a slow and measured approach to cleaning up bad debt. That’s resulted in a very low correlation between Chinese banks’ reported bad debt and China’s GDP growth.
Second, the government is providing targeted stimulus aimed at keeping asset-quality high and the supply of credit flowing, particularly to small and mid-sized enterprises (SMEs) and corporates in Hubei province, ground zero for the outbreak. (Few lenders can complete due diligence in the area, which is effectively on lockdown.)
Private SMEs represent only 7% of loans on Chinese banks’ balance sheets, thanks to banks’ unwillingness to loosen underwriting standards and poison the well. But SMEs are the most vulnerable segment in the bank-loan pipeline. Most cannot survive more than three months, given current cash reserves. Their biggest cash outflows come from employee salaries and social-security expenses; rental expense; interest and repayment of principal on bank loans; and tax expenses.
Accordingly, various government authorities, including the Bank of China and the Ministry of Finance, are coming to the rescue with targeted measures aimed at lowering the financial and operational burdens of virus-infected SMEs. These include reducing or waiving employers’ social-security contributions; lowering rental costs; providing ample liquidity, reducing interest rates and extending loans; and cutting taxes. All are designed to level the economic costs of the virus across sectors and population centers.
This combination of targeted stimulus and controlled debt cleanup leads us to disagree with some market observers who expect the COVID-19 outbreak to affect Chinese banks’ asset quality across the board. Today, Chinese banks’ non-performing loan (NPL) ratio stands at 1.86%, as officially reported. In our view, banks will keep their NPL ratio within a range of 2% to 3%. If stimulus is even more aggressive than we currently expect, Chinese banks could even maintain an NPL ratio below 2%.
But what if the government doesn’t respond with adequate stimulus, and the crisis extends into the second half of 2020? In this case, we would expect other areas of the bank-loan portfolio to experience hits to asset quality, which together could drive the NPL ratio above 3%:
Consumer loans (10% of all lending) and residential mortgages (12%). Since the SARS crisis of 2003, consumerism and services have been much bigger drivers of China’s GDP. If the outbreak sparks widespread job loss and wage growth declines, the impact on the asset quality of personal loans could be substantial.
Developer loans (11%). Potentially fewer loans to home builders would mean a decline in home sales, which would be especially harmful to GDP growth.
Loans to local state-owned infrastructure companies (25%–30%). If developers dial down construction and land purchases, which make up one-third of local governments’ revenues, it would weaken local jurisdictions’ capacity to support these companies.
But that is not our base-case scenario. We are convinced that China’s government won’t let the crisis get that far.
Select Industries to Endure Near-Term Pain
Outside of SMEs, several other Chinese sectors will suffer fallout from the epidemic—albeit mostly over the near term. Here’s what to expect:
- Wholesale and retail trade, catering and accommodation, transportation and logistics, cultural, and tourism. Travel restrictions and widespread shutdowns of business and production would hurt SMEs serving these industries. A lasting pandemic would increase the drawdown.
- Real estate and development. January and February normally account for 8% to 9% of annual construction starts and sales volume for the year. We think home sales and construction should bounce back quickly, once central and local governments phase out the most severe restrictions on travel and business. Indeed, we’re already seeing some signs of recovery. Developers, which are running much bigger balance sheets and faster turnover models, will need astute liquidity management to meet their short-term obligations and prosper.
- Industrials. According to China Iron and Steel Industry Association, crude steel production is up almost 9% year over year and is only slightly lower than its all-time peak of 2.9 million tons. But copper and iron ore prices have declined between 5% and 10% this year over concerns about shrinking demand in China. And the supply-and-demand outlook from mining companies is still unclear for any outbreak scenario.
- Manufacturing. Companies on the Belt and Road Initiative and those that serve US firms that make their goods in China are already bracing for impact to first-quarter earnings due to the trade war. Disruptions to the supply chain due to the coronavirus only adds to the pressure. Should the epidemic worsen, President Xi will need to decide whether to tap the production brakes again—and risk losing China’s long-standing manufacturing dominance to overseas competitors.
Given a wide range of possible outcomes, significant uncertainty and varying degrees of visibility for China’s markets in the midst of an epidemic, we can be most certain of one thing: COVID-19 will continue to fuel market volatility.
In this environment, we favor dynamic, balanced strategies that pair high-quality government debt with higher-yielding, return-seeking assets in a single portfolio. This is mainly because the return streams tend to be negatively correlated; one does well when the other struggles. This is particularly advantageous for investors who want to limit their downside risk without giving up too much yield.
Investors in Asian credit should also be selective in their exposures to industries that will suffer the worst of the crisis over the near term. While China’s bond markets offer great potential, it’s worth keeping a close eye on liquidity buffers and access to funding. Above all, though, investors should think long term. Like the Chinese people, the markets are resilient.