Adamas’ view on private credit with respect to recent market movements – light at the end of the tunnel?

 

By Private Investments Team
August 2015

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness”. This opening paragraph of Charles Dickens’ A Tale of Two Cities aptly sums up the topic of China as an investment theme in many boardroom discussions lately. Unlike most previous years, the topic is not whether to double down on China, it has been whether to hold or reduce exposure to a particular sector or even the country overall. China’s economy grew by 7% in the second quarter and momentum has continued to slow into the second half of 2015. Growth in industrial production, fixed asset investment, retail sales and exports have all fallen. Foreign-exchange reserves have fallen from $4 trillion to $3.65 trillion over five quarters. Around half of that $350 billion decline represented hot-money outflows. These culminated in the forced surprise devaluation of the RMB on Aug 11. So where are the opportunities in China? How should investors position themselves and what are the consequences of the recent market movements?

Rising debt – but manageable:

China’s economic rise since the financial crisis has been fuelled by a massive stimulus campaign started in 2008, which was largely supported by a rapid increase in debt as shown in Figure 1 below. China’s debt as a share of its economy increased by 80 percentage points between 2008 and 2013 and currently stands at around 240% of GDP. This headline debt level has led some investors to worry and fear an imminent debt bubble burst.

However, diving into the numbers and the background of the ‘so called’ debt binge, one would see that the problem lies in the rate of debt growth and not in the level per se. Even at 240% of GDP, China’s total debt is not excessive when compared to many large industrialized nations as shown in Figure 2. China’s rapid increase in leverage was driven by a combination of structural and cyclical factors. Structurally, controls on bank deposit and lending rates have historically reduced borrowing costs in the economy. This has created incentives for corporates to borrow and invest excessively, at the expense of depositors. The bias towards excessive borrowing worsened from 2009, when the government implemented a massive investment-driven stimulus, financed mostly by debt. In subsequent years, a huge amount of credit was channelled into unproductive sectors of the economy, fuelling substantial overcapacity in real-estate and industrial sectors. Inefficient usage of credit, combined with considerable slippage, resulted in GDP growth failing to keep up with debt growth, lifting the overall debt ratio in the economy….

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