As the Chinese authorities inject a fresh $1trn in new credit in the first quarter of 2016, Economist Marcus Wright examines this latest development and what it means for China and the world economy.

1. China: kicking the can
down the road
Marcus Wright, RBS Economics, April 2016
1

2. Information classification: Public/Internal/Confidential/Secret 2
What’s this all about?
• China has reverted to what it knows best – engineering a credit boom to
support investment.
• It will likely delay China’s hard-landing.
• But only temporarily. China has been getting less growth bang for its credit buck
since the crisis.
• It doesn’t change our fundamental view of China’s economy – it remains beset
by major problems including over-capacity in key sectors and hidden non-
performing loans in the banking sector. The proverbial can is being kicked
down the road.
• It’s a short-term positive for the global economy. It might make 2016 “okay, but
not great” rather than deteriorate further. But it won’t be enough to throw
lower for longer off track.
• China’s medium-term financial stability risks have increased. And the UK is
financially exposed.

3. Information classification: Public/Internal/Confidential/Secret 3
• China has engineered yet another
credit boom to arrest the sharp
drop in growth.
• New financing into the economy in
Q1 was the strongest on record.
• If all that financing was an economy
on its own it would be the world’s
16th biggest, not far off the size of
Mexico.
• While we previously stated that
policy making was not calibrated to
the economy’s needs it has now
shifted even further away from
what is desired.
• The proverbial can is being kicked
down the road.
0
200
400
600
800
1,000
1,200
1,400
1,600
China Q1 New Financing v Economy
Ranking
($ Bn)
China - Q1 2016 New Financing
Source: Bloomberg , IMF
1. China has reverted to what it knows best
-
1,000
2,000
3,000
4,000
5,000
6,000
7,000
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
China - New Financing
(Yuan Bn)
Source: Bloomberg

4. Information classification: Public/Internal/Confidential/Secret 4
• China is locked into a credit-
intensive form of growth.
• The credit binge is being supported
by fiscal expansion - the planned
fiscal deficit for 2016 will be the
biggest in at least 34 years.
• China on the face of it has plenty of
room for fiscal expansion. Public
debt is merely 30% of GDP.
• But that excludes local government
debt. It could be as well over twice
the 30% figure.
• And the government will likely have
to pay for a significant banking
sector bailout in the coming years.
2. It’s the third distinctive credit wave since the crisis,
and it’s supported by fiscal expansion
-3
-2
-1
0
1
2
China - Fiscal Balance
(% of GDP)
Source: IMF, China NPC
2016 Target
announced at
NPC
0
500
1,000
1,500
2,000
2,500
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
China - Monthly
New Financing
(Yuan Bn)
Source: Bloomberg
1. Post-Crisis
Response
2. The post-crisis
response credit
pick-me-up
3. 2016
Boom

5. Information classification: Public/Internal/Confidential/Secret 5
• The renewed credit deluge seems
to have arrested the decline in
growth.
• After slowing significantly in
2015, much more than the
headline figures suggest, China’s
growth may have bottomed,
temporarily at least.
• Real estate and infrastructure
investment growth rates have
risen into Q1.
• Even steel seems to be on the up.
• The usual build-up of steel
inventories over the winter was
much less than usual. And it’s
already being drawn down.
3. It seems to have got traction
0
5
10
15
20
25
30
China - Fixed Asset Investment
(% Y/Y Change)
Real Estate
Infrastructure
Manufacturing
Source: Bloomberg
0
1,000
2,000
3,000
4,000
5,000
6,000
China - Steel
Futures
(CNY)
Source: Bloomberg
0
100
200
300
400
500
2012 2013 2014 2015 2016
China - Winter Steel
Inventory Build
(Rebar)
Source: Bloomberg

6. Information classification: Public/Internal/Confidential/Secret 6
• The authorities have engineered yet
another house price boom.
• Easier credit and a reduction in the
required deposits for first-home
buyers (from 25 to 20%) and second
home buyers (from 40 to 30%) have
helped.
• House prices in the largest cities
(Shanghai, Beijing, Shenzhen,
Guangzhou) rose a staggering
30%y/y in March.
• But the market remains afflicted by
oversupply.
• China’s house prices are prone to
wild swings. The next downturn is
unlikely to be too far away.
4. House prices are on the rise but…..
-10
0
10
20
30
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
China House Prices
(Newly Built, % Y/Y Change)
Tier 1 Cities Tier 2 Cities Tier 3 Cities Source: Bloomberg
0
10,000
20,000
30,000
40,000
50,000
-10
-5
0
5
10
15
20 China - House Prices v
Floor Space for Sale
House Prices (All Cities - % Y/Y Change) - LHS
Residential Floor Space for Sale (10,000sqm) - RHS
Source: Bloomberg

7. Information classification: Public/Internal/Confidential/Secret 7
• China’s post-crisis credit waves have
been getting less growth bang for
their buck.
• More and more capital is needed to
produce an extra unit of output.
• The return on capital has been
declining steadily since the crisis, as
it has across emerging markets as a
whole.
• So there are doubts about how long
this latest growth fillip will last.
• It could fizzle out before the end of
the year.
5. Less growth bang for its credit buck
2
2.5
3
3.5
4
4.5
5
5.5
1995 1997 1999 2001 2003 2005 2007 2009 2011 2013
China - Incremental Capital
Output Ratio
Source: OECD
4
6
8
10
12
14
2001 2003 2005 2007 2009 2011 2013 2015
MSCI China - Return on Capital
(%)
Source: Bloomberg

8. Information classification: Public/Internal/Confidential/Secret 8
The economy remains beset by:
• an excessive reliance on investment to drive growth
• a structurally low share of GDP going to household incomes
• over-capacity in key sectors
• hidden non-performing loans in the banking sector
• ad-hoc, reactive policy-making that fails to address the underlying
distortions in the economy – the transition to a less debt-addicted,
less investment-driven growth model remains some way off
6. It doesn’t change our view on China

9. Information classification: Public/Internal/Confidential/Secret 9
• China’s rapid debt build-up has been
matched by sharp rise in the cost of
servicing that debt.
• It is widely agreed that China’s banks
are sitting on non-performing loans
well in excess of official figures. But
estimating the true size of the
problem is very difficult.
• Our own estimate is the NPL ratio is
around 25%. In the most pessimistic
scenario NPLs are closer to 35%.
• We maintain the view that China
won’t experience an out and out
crisis.
7. A more painful day of reckoning awaits
15
18
21
24
27
30
33
100
120
140
160
180
200
220
240
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
China - Debt to GDP
and Debt Servicing (%)
Household and Corporate Debt as % of GDP - LHS
Debt Servicing as Share of GDP (%) - RHS Source: BIS, Bloomberg
0%
5%
10%
15%
20%
25%
30%
35%
40%
Reported Optimistic Central Pessimistic
China - Estimating Banking Sector
NPL Ratio (%)
Source: IMF, Penn World Tables, Bloomberg, Macrobond, RBS Economics

10. Information classification: Public/Internal/Confidential/Secret
-
200
400
600
800
1,000
1,200
1,400
1,600
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Financial Exposure
to Ch & HK ($ Bn)
World UK
Source: Macrobond 10
But the consequences of its credit boom will be
far from painless. In the coming years we think
China will experience:
• a balance-sheet recession (the debt
hangover) as debt-burdened corporates
prioritise debt minimisation;
• an impaired (eventually) banking system,
constraining the reallocation of credit and
productivity growth;
• a hangover of misallocated labour from the
financial boom, also constraining
productivity growth;
• an inadequate reform effort.
Our ‘not a blow-up, but many difficult years’
view on China remains.
8. China’s challenging future
The risk from financial exposures
• It’s too early to tell whether global financial
exposures to China have increased in recent
months in tandem with the credit boom.
• But even if it hasn’t, the latest credit deluge
increases medium-term financial stability
risks in China.
• The UK’s exposure to China is a concern.

11. Information classification: Public/Internal/Confidential/Secret 11
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12. Information classification: Public/Internal/Confidential/Secret 12
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