Month: July 2023

“Why is Richard Koo’s profile rising in China?”

Because the Chinese government knows there is a disease called “balance sheet recession”.

The key chart

Trends in “excess credit growth” in China since December 2012 (Source: BIS; CMMP)

The key message

“The Chinese government knows that there is a disease called balance sheet recession, and they should know how to handle it”

Richard Koo, quoted by Bloomberg on 10 July 2023

Richard Koo is the Chief Economist at the Nomura Research Institute who developed the concept of “balance sheet recessions”. These recessions occur when “a nationwide asset bubble financed by debt bursts” (Koo, 2008). According to a Bloomberg article this week, “Koo’s ideas are being taken seriously in China”.

In this post, I explain why this is the case. I revisit my January 2023 arguments and update the data points and charts from “The missing link in the China re-opening story?”. I begin with the same question that I posed at the start of the year:

What happens if rather than seeking to maximise profit/utility as traditional economics assumes, the Chinese private sector (PS) turns to minimising debt or maximising savings instead? What if China experiences a balance sheet recession?

What does the data tell us?

While China’s PS indebtedness has declined from its 3Q20 peak, it remains above Japan’s “peak-bubble” level. Affordability risks remain elevated in China too. The PS debt ratio is not only high in absolute terms, but it is also elevated in relation to its long-term average. Chinese debt dynamics have shifted from excess growth in corporate credit growth, through excess growth in household debt, to a “passive deleveraging” phase. The risk remains that this extends to full PS debt minimisation i.e., a balance sheet recession.

Following recent re-intermediation, the Chinese banking sector is relatively exposed to the risks associated with these dynamics. The bank sector debt ratio exceeds the level reached at the height of the Spanish private sector debt bubble, for example, and is currently the highest ratio among BIS reporting economies.

What are the implications?

China’s debt dynamics point to potential demand (debt minimisation) and supply side (bank sector debt) constraints to future consumption.

From a policy perspective, Koo argues that the Chinese government must ramp up spending to offset private sector deleveraging. According to Bloomberg, he recommends a fresh wave of fiscal stimulus, targeted towards the real estate sector.

From an investment perspective, these factors need to be included in the investment narrative. It was a mistake to ignore private sector debt dynamics at the start of the year. It is a mistake to ignore them now…

Why is Richard Koo’s profile rising in China?

Personal background

I met Richard Koo in Tokyo when I was a graduate trainee at Nomura Securities in 1986. I left Nomura in 1988 to build the top-rated Japanese equities team (for European clients) at Baring Securities. I subsequently moved on from Japanese equities in the early 1990s to develop a career in banks research and macro strategy. I continued to follow Koo’s work, read his books and applied his approaches to my own analysis of monetary and macro developments in other advanced and emerging economies. We share a common analytical foundation based on a sector-balances framework.

My January 2023 message

In January 2023, I questioned the so-called “China re-opening” narrative. My scepticism centred on the level of Chinese private sector debt, the growth in HH debt and the affordability of private sector debt.

I asked, “What happens, for example, if rather than seeking to maximise profit/utility as traditional economics assumes, the Chinese private sector turns to minimising debt or maximising savings instead? What if China experiences a balance sheet recession?”

The July 2023 update

Trends in Japanese, Spanish and Chinese PS debt ratios since 1980 (Source: BIS; CMMP)

China’s private sector indebtedness exceeds the “peak-bubble” level seen in Japan in 4Q94. The private sector debt ratio was 220% GDP at the end of 4Q22, below its recent 225% peak but still above Japan’s peak debt ratio of 214% GDP. Note the similarity in debt ratio trends in Japan (debt bubble), Spain (debt bubble) and in China (see chart above). History rhymes…

Trend in the Chinese PS debt service ratio since 2000 (Source: BIS; CMMP)

Private sector affordability risks remain elevated too. The private sector debt service ratio (PS DSR) is not only elevated in absolute terms (20.6%) but it is also elevated in relation to its long-term average (15.7%). The PS DSR peaked in 3Q20 (see chart above) and has trended between 20-21% since then.

Trends in stock of HH and NFC debt (RMB tr) and PS debt ratio (% GDP, RHS) (Source: BIS; CMMP)

The Chinese private sector has already entered a period of passive deleveraging (see chart above). In other words, while to outstanding stock of debt continues to increase, it has been growing at a slower pace than nominal GDP since 3Q20.

Chinese debt dynamics have shifted from excess growth in corporate debt to excess credit growth in household debt and then to passive deleveraging. The risks remain that these trends extend to an extended period of private sector debt minimisation – i.e., a balance sheet recession.

Bank credit as a percentage of total PS credit (%) since 2007 (Source: BIS; CMMP)

With recent re-intermediation (see chart above), the Chinese banking sector is relatively exposed to the risks associated with current debt dynamics. The bank sector debt ratio (see chart below) exceeds the level reached at the height of the Spanish private sector debt bubble, for example, and is currently the highest ratio among BIS reporting economies (excluding Hong Kong).

Trends in Japanese, Spanish and Chinese bank sector debt ratios (% GDP) (Source: BIS; CMMP)

Conclusion

China’s debt dynamics point to potential demand (debt minimisation) and supply side (bank sector debt) constraints to future consumption.

From a policy perspective, Koo argues that the Chinese government must ramp up spending to offset private sector deleveraging. According to Bloomberg, he recommends a fresh wave of fiscal stimulus, targeted towards the real estate sector.

From an investment perspective, these factors need to be included in the investment narrative. It was a mistake to ignore private sector debt dynamics at the start of the year. It is a mistake to ignore them now…

Please note that the summary comments and charts above are extracts from more detailed analysis that is available separately.

“How high would the UK base rate have to go…”

…for debt vulnerabilities to return to GFC levels?

The key chart

Share of UK HHs with mortgage COLA-DSRs above 70% (Source: BoE Financial Stability Review, July 2023)

The key message

How high would the UK base rate have to increase for HH debt vulnerabilities to return to GFC levels? To around 9% according to the Bank of England today, up from a broader, estimated range of 5-8% indicated a year ago…

The Bank of England (BoE) held a press conference regarding its July 2023 Financial Stability Review (FSR) this morning (12 July 2023). As always, the question and answer session was particularly important not least in the request for clarification on rising HH debt vulnerabilities.

Recall that a year ago, Sir Jon Cunliffe, the Deputy Governor for Financial Stability, was asked for clarification on this topic – how far would interest rates have to rise for HH debt vulnerabilities to reach the GFC peak levels?

In response, he indicated that rates would have to rise by between 200-500bp above the existing market expectations. These were 3% at the time. In other words, the base rate would need to return to between 5% and 8% for debt vulnerabilities to return to the GFC levels. Today’s UK base rate is 5%, at the bottom end of this range.

In the latest FSR, the Bank of England returned to this topic. The Bank stated that, “The proportion of HHs with high mortgage cost-of-living-adjusted debt-servicing ratios (COLA-DSRs) is expected to continue to increase [from 2% in 1Q23] to around 2.3%…by the end of the year. But it would stay below the recent peak reached in 2007 of 3.4%.” (see key chart)

Importantly, the report then notes that, “To reach that peak level by the end of 2024, it would require mortgage rates to be around three percentage points higher relative to current expectations [c.6%], other things being equal.”

In short, the BoE has narrowed the range and increased the level of the base rate that would lead to a return of GFC levels of HH debt vulnerabilities – to 9%.

The main reason, according to Sir Jon Cunliffe, is the level of support provided by banks in terms of extending mortgage terms, changing mortgage terms and supporting moves to interest-only mortgage. In other words, more options and support from banks has given slightly more “breathing room” before debt vulnerabilities return to their recent 2007 peak.

A year ago, I felt that the BoE was verging on complacency in terms of rising HH debt vulnerabilities. Ninety days later the tone of the message changed and higher risks acknowledged. Today, we have a narrow and clearer “risk target” but the body language was less-than-convincing, in my opinion.