Special Issue: Wide implications of China's credit contraction

24 August 2017 19:31 Source:ICIS Chemical Business

There was a lot of unhelpful and distracting noise surrounding the release of China’s official year-on-year H1 GDP growth figure that came in at an unexpectedly strong 6.9%.

Equally misleading was the pick-up in June total social financing (TSF). This was taken as an indication that China is backing away from its efforts to rein-in its credit bubble.

Add this to the unexpectedly strong export and import figures for the first half of the year, and you might mistakenly reach the conclusion that China’s GDP growth definitely is not going to slow down in the second half of this year and into 2018. Why this would be wrong is because of the lag effect of what is, in fact, a major pull-back in China’s lending growth.

It will take one more quarter or longer before this reduction in new credit starts to be reflected in both the official GDP numbers and independent growth estimates. A deeper dive into the lending data, below the level of the headline TSF figures, tells the real story.

And instead of backing away from tackling its credit bubble, China looks set to continue with the lending clampdown. This is evident from recent regulatory changes and the strong language in the state-owned press about the need to get rid of bad lending practices.

The health of the global economy is largely about China’s credit cycles. The global deflation we saw in 2014-2015 was because of China’s previous attempt to tackle excessive and risky leverage. This led to lower global growth.

We were back to reflation in 2016 – with a carry-over effect into the first half of this year – because of China’s decision to once again relax lending conditions.

The return to reflation forced western purchasing managers to stock-up on Chinese finished goods exports in an attempt to beat future cost increases.

Chinese manufacturers had to thus import more raw materials to both meet this better export demand, as they also attempted to hedge against higher input costs. This explains why China’s export and import growth was strong in the first half of the year, and also helps to explain a broader pick-up in global trade.

The Netherlands Bureau for Economic Policy Analysis said world trade volumes grew by 5% in the three months to May compared with the same period a year earlier. And the return to mild reflation and the pick-up in global trade have been major factors behind stronger global economic growth. If we therefore once again see China return to exporting deflation as it renews its assault on excessive lending, global growth is likely to slip. We might even end up in a new global recession, perhaps even a new economic crisis, as the west confronts fundamental long-term economic problems that current monetary and fiscal policies are failing to address.


All the extra credit surging around the Chinese economy helps to explain a sharp rise in the first quarter in some of the country’s petrochemicals imports, most notably polyethylene (PE). PE net imports (imports minus exports) were up by 26% in the first quarter of 2017 over the same period in 2016 to around 3m tonnes, according to China Customs department data.

This is despite domestic production also increasing in the first quarter, again on a year-on-year basis, by an ICIS China estimate of 11% to 4m tonnes. Put this data together and this resulted in an increase in apparent demand (net imports plus local production) of 17%.

This is way ahead of the ICIS Consulting forecast for real PE demand growth for the full-year 2017 over 2016. By the end of this year, we are predicting consumption will be at around 27m tonnes – a 5.7% average increase across all the PE grades compared with 2016. Real PE demand growth is growth adjusted for inventory distortions.


What happens next, for the global economy and petrochemicals, is all about the future of lending growth in China. And that growth has significantly slowed down, with a further reduction in its growth very possible.


TSF, which is a broad measure of credit and liquidity in the economy, rose to yuan (CNY) 1.78tr ($262.22bn) in June from CNY1.06tr in May. For the first half of the year as a whole, growth in TSF remained strong compared with H1 2016.

But what matters more than these headlines numbers is what is referred to by economists as the “credit impulse”. This is a term coined by Michael Briggs in 2008, who at that time was an economist with Deutsche Bank.

What credit impulse means is the change in new credit issued as a percentage of GDP. Briggs argued that private sector demand in most countries correlated very closely with credit impulses, rather than with the total stock of credit. Declines and increases in the total stock of credit is reflected in statistics such as China’s headline TSF numbers.

China’s credit impulse declined by no less than 17.5% year on year in the first quarter, according to William Sterling, chief investment officer at Trilogy Global Advisors.

“By our measure, the magnitude of this negative credit impulse has only been matched or exceeded a few times – in 1994, 2004-05 and 2010,” wrote Sterling in an 18 July Financial Times (FT) Beyondbrics blog post. But he added that in those previous periods the negative credit impulse came against the backdrop of very robust growth in nominal GDP – 37% in 1994 and 18% in both 2004 and 2010.

China’s nominal GDP grew by a relatively small 11.8% in Q 2017 versus the same period last year. This suggests that the impact of the credit slowdown could be greater on this occasion than in the past.

As everyone knows, a big driver of China’s stronger GDP growth in 2016 and H1 2017 has been a booming real estate market.

But Fitch Ratings believes that a weaker credit impulse, combined with the tightening of home purchase restrictions, will reduce the growth in home sales during the second half of this year.

New home sales measured by floor space dropped by 46% year on year in July in the first-tier cities – Beijing, Shanghai, Guangzhou and Shenzhen. Sales also fell by 23% in 16 key second-tier cities, which include Hangzhou and Nanjing.

A further dive into China’s lending data shows there has been a sharp decline in financing available via China’s shadow banking sector, according to Paul Hodges, chairman of UK-based chemicals consultancy, International eChem.

He estimates that it peaked at a three-month rolling average of $157bn in January this year, but then fell to an average $23bn in the second quarter.

Why these numbers matter is that shadow or private lending is highly speculative, and is thus the main target of the government’s lending restrictions.

The boom in shadow lending also helps to explain the big pick-up in GDP growth in 2016 and in H1 2017.


Sterling also wrote in the same blog post: “The most important global policymaker nobody has ever heard of is Guo Shuqing, the recently appointed chief of the China Banking Regulatory Commission.

“With the implicit support of President Xi Jinping, Mr Guo has issued a flurry of new regulations aimed at tackling corruption and speculation, including a requirement that banks account for previously lightly regulated wealth management products (WMPs), in line with capital adequacy regulations.”

WMPs are off balance sheet investment products that don’t fully show up in official lending figures, and are highly risky. In July 2017, during its annual National Financial Work Conference, Beijing also announced the establishment of a new cabinet-level committee to better coordinate China’s financial regulators and tackle systemic financial risk.

And as Hodges also points out, the conference was this year presided over by President Xi, whereas normally the meeting is run by the less senior premier or prime minister.

You should also take note of the very strong language in this 19 July editorial in the state-run newspaper, The Global Times:

“Admittedly, there are worries about the impact of supervisory tightening on the country’s financial innovation, notably in the world of fintech, considering that rapid innovation in the financial sector is seen intertwining with the rise of shadow credit that plagues the Chinese economy. But that should by no means be an excuse for further shadow lending indulgence.

“These could easily turn into a nightmare for the Chinese economy if allowed to run their course without hindrance. China can hardly make great breakthroughs in economic reforms if it fails to tame rampant debt.”


Tracking the tone of editorials in the state-owned press is a useful tool to monitor the pace of economic reforms. Over the last six months, the tone across nearly all of these editorials has changed. Government officials who either directly or indirectly authored these articles have started to consistently warn about tougher economic times ahead, and the need to sacrifice short term growth for longer term gains.


The monetary tightening that we have seen in China so far this year has dampened the mood in the key China PE market. Plastic converters are increasingly finding it harder to get hold of trade financing, and we expect this to continue into 2018. It is and will remain the same across many other petrochemicals and polymers.

Since Q1, the converters have also cut back on their purchases of imported PE because of the big surge in shipments to China during the first quarter. This left inventories among China’s converters and traders at very high levels.

A further factor holding plastic processors back from import markets has been a wider gap between the cost of imported and domestic material. The sharp rise in local production has led to some very competitively priced domestic commodity grades of PE.

We have thus seen a sharp fall in imports since the first quarter. As we said earlier, Q1 net imports rose by 26%.

But H1 net imports were only up by 11% at approximately 5.2m tonnes. Meanwhile in H1 2017, domestic production rose to around 5.2m tonnes, which was again 11% higher than H1 2016.

As for apparent demand, the year-on-year increase in the first half of the year was 7%, a steep drop from the 17% in the first quarter – and much closer to our forecast for real demand growth during the full-year 2017 of 5.7%. The $64,000 question is how much further import growth will fall during the rest of this year, and into 2018, as China’s economy cools down.

This question is creating a great deal of anxiety among global PE players because the importance of China’s market. There is no other market like China in terms of the scale of its PE deficits.

And China’s ability to absorb imports has taken on even more important because of the rapid build-up in global PE capacity that is taking place in 2017-2020.

Focusing just on linear low density PE (LLDPE), we expect China’s deficits to total around 2.7m tonnes in 2017 and we expect the deficit to grow to around 4.1m tonnes by 2020. The only region that comes close to China when measured by import requirement is Europe. Its LLDPE imports are expected to rise from 2m tonnes this year to 2.3m tonnes in 2020.

Across the three grades of PE, the new capacity surge is particularly pronounced in LLDPE. Take the US as the most important example here because of the big scale of its capacity additions that have been driven by record-low ethane feedstock costs.

Its LLDPE capacity is set to rise from 5.1m tonnes/year in 2016 to 8.9m tonnes/year in 2020 – a 73% increase.

We do not expect anything other than a moderate slowdown in the Chinese economy over the next one to four years. There is a risk that China suffers a major debt-induced financial crisis, but we see this as a minor risk. But still, any moderation in growth that then results in PE demand lower than is being forecast would be a major challenge for the global industry as it significantly ramps-up capacity. And in the case of the US, its track record in China has become worse over the last 10 years. In 2016, it exported 460,000 tonnes of all grades of PE to China, down from 1m tonnes in 2006, according to China Customs department data.

The US might thus face the challenge of raising exports to China from a much lower base than a decade ago when demand growth in the key China market is lower than had been widely expected.

At the same time, competition will be building from capacity additions in India and the Middle East. India’s Reliance industries, for example, started up 550,000 tonnes/year of new capacity in mid-2017.

But the much bigger deal for global PE – and the petrochemicals industry in general – is the effect that a moderate slowdown in China could have on the global economy.


Building up lots of debt isn’t a problem if it leads to inflation that then inflates-away the value of some of that lending. And debt-induced healthy increases in inflation also show that all of that lending has worked, as these levels of inflation point to snug employment markets and strong wage growth.

Ample availability of jobs that pay good money also guarantees strong demand growth as 1) Consumers have more money in their pockets, and 2) They are anxious to buy goods and services now, rather than tomorrow, in order to hedge against future price rises.

The only challenge central banks would then face would be raising interest rates at the right pace, and by the right amounts, that avoid choking-off inflation to the point where economic recoveries come to an end.

But we are in a vastly different world to what the Fed, and all the other western central banks, imagined when they began their ultra-loose monetary policies back in 2009. The reason is that, despite strong job creation in countries such as the US, income levels are stagnating.

A July 2016 McKinsey study found that “between 65 and 70% of households in 25 advanced economies, the equivalent of 540m to 580m people, were in segments of the income distribution whose real market incomes – their wages and income from capital – were flat or had fallen in 2014 compared with 2005”. This compared with less than 2%, or fewer than 10m people, who experienced this phenomenon between 1993 and 2005, said the same study.

“Today’s younger generation is at risk of ending up poorer than their parents. Most population segments experienced flat or falling incomes in the 2002-12 decade but young, less-educated workers were hardest hit,” added McKinsey.

The rise of the “gig economy” and zero-hours contracts means nothing has changed since 2012-2014 – the end of the McKinsey survey period. In fact, conditions for squeezed middle-income earners in Western economies have got considerably worse.

This explains why inflation in the west, despite eight years of record-high levels of monetary stimulus, remains either close to the bottom of or below the target ranges set by central banks.

The anomaly of tight labour markets but poor or even negative wage growth has been explained away by automation reducing the bargaining power of workers.

As robots and artificial intelligence get smarter and smarter, better-paid jobs are increasingly being done by machines. This has concentrated employment growth in lower-value occupations, such as fast food restaurants. And, of course, globalisation is also blamed for the collapse of the bargaining power of workers with the backlash against jobs drifting overseas helping to explain Trump in the White House and the Brexit vote.

We won’t get into the arguments of the rights and wrongs of these two theories behind stagnant wages in the west.

All we will say is that both of these arguments miss the main point. The main point is demographics. The retirement of the Baby Boomers means that no matter how much longer interest rates remain low, and how much more debt is built-up in developed economies, inflation is still likely to fail to consistently return to the levels we saw in the 1970s and 1980s.

The heart of the problem is the absence of enough young people joining the workforce to replace all the retiring Baby Boomers. Too much supply is, as a result, chasing too little demand, leading to deflationary rather than inflationary pressures. Here is a full explanation about why we are where we are today:

  • It was the Baby Boomers that gave a tremendous one-off boost the US economy – and the global economy as well. US births rose by 52% in 1946-1964 compared with the previous 18 years.
  • Another important one-time demographic boost to demand was the arrival of women in far-greater numbers in the workforce. Growth in dual-income households and immigration were responsible for between 15% and 20% of growth in aggregate US output over the past half century.
  • This led to too much demand chasing too little supply – hence, the jump in US inflation and an explosion of innovation. Companies invested heavily in R&D, and then in the commercialisation of all these fantastic ideas, because the demand justified the effort. So we also saw many years of high productivity growth.
  • But since 1970 US birth rates – and those across the West in general – have been below 2.1 per mother. This is below the population replacement level.
  • In 2001, the oldest Boomers began to join the New Old 55+ generation. As you first approach retirement you spend less money, as of course you are saving for your retirement. When you actually retire your spending declines even further as 1) You have already bought most of the things that you need and 2) You are living on your pension income.
  • We have thus seen a collapse in inflation as too much supply chases too little demand. Companies have also stopped innovating, as today’s demand levels are not worth the effort. This helps to explain the fall in productivity growth.

Meanwhile, exceptionally lax monetary policies since the 2008 Global Financial Crisis have led to a huge build-up in global debt, warned the Bank for International Settlements (BIS) in a June 2017 study.

It estimated that aggregate global debt ratios are almost 40 percentage points of GDP higher than a decade ago. What this build-up of debt in the west has done is inflate asset bubbles, such as real estate. But it has failed to lift the wages of average income earners, for all the reasons given above.

And now comes the risk of policy normalisation as the US Federal Reserve and other western central banks raise interest rates and cut back on quantitative easing.

“Policy normalisation presents unprecedented challenges. [It could] trigger or amplify a financial bust in the more vulnerable countries,” wrote the BIS in its June study.

And as we said, normalisation of monetary policy in the west is occurring as China once again tries to tackle its own lending bubble.

As legendary investor Warren Buffett so famously wrote about investment cycles: “Only when the tide goes out do you discover who’s been swimming naked.” Signs of excessive risk taking, which are a direct result of lax monetary policies, include the US auto loans market. As the Financial Times wrote in a 30 May article: “Just as with mortgages, the car loan business has grown rapidly. Total auto loans outstanding came to $1.17tr at the end of the first quarter of this year, according to the New York Federal Reserve, up almost 70% since a post-crisis trough in 2010. That has helped push total household debt to $12.7tr, surpassing the 2008 peak.”

Is this another subprime mortgages disaster? Probably not. Steve Eisman, the fund manager (now with Neuberger Berman) who helped inspire The Big Short, the best of all the books about the US mortgage crisis, told the FT: “At the height of subprime mortgages, the standard was, ‘Can you breathe?’ It never got that bad in subprime auto. They definitely checked your pulse.”

But still, levels of US consumer auto debt suggest a sharp fall in new vehicle sales – especially as the Fed appears to be in tightening mode. Rising interest rates will make new auto loans less affordable.

Further, the Fed’s giant monetary stimulus programme has created false demand. US consumers were lured into buying vehicles that they did not really need because financing terms seemed too good to turn down. Might some petrochemicals projects end up falling into the same category? Could it for example be the case that some of the PE plants built in the US have been built to serve real, sustainable demand that does not actually exist?

And more importantly, if both the western central banks and China continue on their current monetary tightening cycles, the risk of a new global economic crisis cannot entirely be ruled out as bad lending in autos, petrochemicals and real estate starts to unravel.

China's lending growth is out of control

Wind the clock back to late 2008. China’s leaders were at that time very concerned about the impact of the Global Financial Crisis on their country’s economy, as the collapse in export orders from the west threatened millions of manufacturing jobs.

They thus launched the biggest domestic economic stimulus package in the history of the world for an economy the size of China’s.

The speed with which lending was increased inevitably led to capital misallocation. Over-capacities built-up across many manufacturing industries including steel, aluminium and some chemicals and polymers.

Factories were often built for the sake of building factories – that is, the short term boost delivered to growth of building activity. Little thought was given to the long term effects on supply and demand in many industrial sectors. Purified terephthalic acid (PTA) and polyvinyl chloride (PVC) are good examples of this.

A real estate bubble also inflated to the point where tens of millions of Chinese people had found themselves priced out of owning property in some of China’s bigger cities.

This left behind a major bad debt problem. Charlene Chu, analyst with Autonomous Research, places China’s non-performing loans at 25% of total lending compared with the official estimate of a bad-loan ratio of just 1.74%.

A rapid rise in auto sales on cheap credit, and the rise in heavy manufacturing capacities, also exacerbated already very serious air, water and soil pollution problems.

What we have seen since 2008 has therefore been a “stop go” process of China relaxing and then tightening lending conditions. To date, we have seen four phases of this process:

  • China increased lending by $10trn in 2009 when its nominal GDP was only $5trn. This contributed to a surge in oil and other commodities prices and supported the global economy as China exported reflation.
  • Growth in lending slowed from early 2014 onwards, which was one of the factors behind the decline in global oil prices from around September of that year. Commodities prices in general slid on a slowdown in the Chinese economy. Lending was down by $4trn by the end of 2015 compared with the beginning of 2014. Growth in the global economy moderated as China started to export deflation.
  • Last year, China once again took the controls off its financial system, resulting in a renewed surge in credit growth. This once again boosted commodities prices and the global economy. Chu estimates that lending grew by 19% in 2016 over 2015.
  • We are now in the midst of phase four as China again sharply reduces growth in lending. For example, China’s all important credit impulse fell by 17.5% in Q1 2017 over the year-ago period. China might of course decide to change direction again. But China’s president, Xi Jinping, heads the “princeling” political faction that in recent months has gained much more influence, at the expense of the “populist” political faction.

The princelings are prepared to endure lower short-term economic growth for the sake of longer-term economic reforms, whereas the populists are more ready to resort to quick-fix stimulus.

For the next few quarters at least, it seems likely that the princeling faction will remain in control of the main levers of the economy.

John RichardsonJohn Richardson, senior consultant, Asia, is a highly experienced trainer and chemicals industry journalist, who has been working in the industry for 16 years. Based in Asia-Pacific, John has deep knowledge of the companies and people who have transformed the region into the world’s major production and consumption region. His aim is to provide insightful, factually based analysis of the key issues facing the industry. Since 2006, John has been Director – Asia of ICIS training, where he has successfully launched the ICIS training business in Asia. This now provides a wide range of courses covering petrochemicals, oil refining, fertilizers and base oils.

By John Richardson