Here’s a widely told yarn: Last year China successfully curtailed skyrocketing debt issuance without hurting growth.
Like all good tall tales, it has some basis in truth. China’s debt-to-GDP ratio did level off in 2017, thanks largely to rebounding exports. What didn’t happen was a sharp slowdown in actual borrowing, until the end of 2017—meaning companies are only now feeling the pinch of tighter credit. Chinese property developer Zhonghong Holding Co. last week defaulted on more than $150 million of debt, raising worries that other financially strapped firms may soon follow suit, spooking global markets as happened in 2016.
As the stress mounts, investors should expect more Chinese policy easing in the months ahead. China’s central bank already unexpectedly cut banks’ reserve ratios last month, releasing about half a trillion yuan ($78 billion) of funds for lending.
One reason that big cut caught markets off-guard is that foreign investors largely misread China’s “deleveraging” campaign in 2017. The key objective wasn’t to curb lending—it was to rationalize bank funding. In the first 10 months of 2017, overall credit growth slowed a paltry 1.4 percentage points to a still-healthy 14.6% from a year earlier, while bank lending actually quickened.
What did change was banks’ own dangerous dependence for funding on short-term interbank borrowing and risky “wealth management products.” The crackdown on these WMPs hit issuance in the corporate bond market, where many of the products had been invested. But Chinese firms were still able to tap other, older forms of shadow financing last year, such as loans from trust companies and so-called entrusted lending, whereby some companies—mostly state-owned and cash-rich—provide their weaker brethren with funds.
On the funding side, banks were forced to curtail short-term borrowing for pricier, but more stable funding from China’s central bank.
A few things have changed recently to upset this happy story. Regulators are now trying to crimp all forms of shadow financing. Overall lending is finally slowing, which is hitting growth: Industrial profits rose just 3% on the year in March, their worst performance since December 2016.
As companies struggle more, banks may find it hard to pass on their higher funding costs. If banks can’t make money, they will lend less—and growth will slow even further. That explains why the central bank is now moving to offset the pressure on banks’ funding costs with the big reserve requirement cut.
For investors watching the Chinese economy and rates, the message is clear: China hasn’t somehow magically cracked the code on debt-free growth. If industrial profits and inflation keep heading sharply lower, expect another round of substantial stimulus before too long.
Write to Nathaniel Taplin at nathaniel.taplin@wsj.com