The chief global economist of Everbright Securities says that it will be impossible for Chinese regulators to implement a successful deleveraging without the economy weathering some hurt.
In his recently published book “Gradually Approaching Financial Cycles” (渐行渐近的金融周期) Peng Wensheng of Everbright Securities provides a trenchant analysis of what he claims are four key areas of misunderstanding when it comes to the deleveraging process – inflationary deleveraging, growth-based deleveraging, corporate deleveraging and debt restructuring, and concludes that a truly painless leveraging will be very difficult for China to achieve.
Inflationary deleveraging involves raising nominal GDP while the nominal value of debt remains fixed, leading to a decline in the debt-to-GDP ratio, as well as an increase in the earning capability of companies, their repayment capability and net assets.
According to Peng this method has the advantages of avoiding a cascade of debt defaults and the attendant shock to the economy, and cutting leverage by means of a simple denominator.
In actuality, however, inflationary deleveraging involves a reallocation of incomes, shifting resources from creditors to debtors to reduce the burden on the later.
Peng further notes that impacts of inflationary deleveraging may be limited in the current situation given that “high leverage is always structured,” and that it’s mainly state-owned enterprises and property-related companies who are heavily indebted at present.
Inflation-fuelling fiscal stimulus may only be of limited assistance to these highly leverage concerns given that it would be primarily directed towards infrastructure investment and social welfare, while the use of monetary supply expansion via increased extension of credit would be contrary to the goal of deleveraging, and could even serve to further inflate asset bubbles.
Peng notes that while monetary expansion by the government can lighten its own debt, in actuality it’s simply replacing one form of “debt that cannot be refused” )money, with another (government bonds), and is serves as an effective method for reducing government debt.
“The fundamental error when it comes to inflation-based deleveraging is to uniformly apply the logic behind reducing government debt in an era of fiscal guidance and financial suppression to the reduction of non-government debt in an area of financial liberalisation and asset bubbles, when the two are fundamentally different,” writes Peng. “The two are intrinsically different.”
Growth-based deleveraging bears affinities with inflationary deleveraging, as it involves tinkering with denominators and reducing debt-to-income ratio, but is also subject to the similar limitations due to the structured nature of economic leverage.
“High leverage is structured in nature and concentrated in a given sector, yet growth in the total economy is scattered across all or multiple sectors,” writes Peng. “In order to achieve a painless deleveraging, comparatively large-scale growth is required, which in reality is difficult to achieve.”
Peng further notes that highly leveraged sectors are precisely the very ones that should be subject to contraction or adjustment because of their contribution to asset bubbles and overcapacity, and their impact upon the efficiency of resource allocation.
History also attest to the difficulty of growth-based deleveraging, with Peng pointing to research showing that successful examples over the past century are extremely few,as well as dependent upon chance external factors.
“The high growth of the US from 1938 to 1943 is believed to have solved the Great Depression of the 1930’s, and a fundamental driver of deleveraging, but this was tied to the Second World War,” writes Peng. “Egypt achieve high-growth deleveraging from 1975- 1979, benefiting from high oil prices brought by the oil crisis.”
Enterprise deleveraging and household leveraging
Some economists advocate increasing household leverage to offset the impact of deleveraging in the corporate sector upon economic growth.
Peng notes, however, that the correlation between companies and households might be too great for one to pick up the slack for the other because of the property sector, and that unique features of the leverage in China might also create challenges.
“Household leverage is mainly concentrated in low income households,” writes Peng. “Affluent households usually enjoy ample cash flows, and less willing to borrower to fuel consumption.”
As a consequence it’s usually households with weak repayment capability that have high leverage levels, and households with strong repayment capability that have low leverage levels.
In Peng’s view this cross-allocation could lead to precise the type of systemic risk that triggered the US sub-prime mortgage crisis, where low-income households fuelled a housing bubble by means of high-leverage, and were the ones to suffer the most once it burst.
Debt restructuring and asset prices
A fourth area of misunderstanding that Peng highlights is debt restructuring, which he says many people believe to lie at the heart of deleveraging.
The use of debt restructuring to help highly leverage sectors to reduce their debt burdens is predicated upon the key assumption that real estate prices won’t change, which in Peng’s view is a major problem for Chinese financial cycles.
“If the debt burden of debtors falls and their asset prices don’t change, then the debtor’s net assets increase, its leverage rate falls, strengthening its ability to take on further debt.
“From the perspective of the financial cycle, although in the short-term debt restructuring achieves the goal of leverage reduction, high property prices will also stimulate a new round of credit creation.”
Moral hazard is also a problem, with those debtors who engage in speculative or unsound investment by means of leverage benefiting, while prudent economic parties whether damage.