China's economy can't snap back from the coronavirus as fast as it did after SARS because it's growing more slowly and the banking system is a mess.
- Wall Street is convincing itself that China will bounce back relatively quickly around the end of the first quarter, when it expects the coronavirus' spread to be contained.
- This is banker delusion. China's economy is growing much more slowly than it was in 2003, when the SARS outbreak hit.
- Plus, the financial sector is in much worse shape. It's loaded with debt, and credit conditions are still deteriorating from bailouts last year. This will all make it much harder to fund struggling businesses and local governments.
- This is an opinion column. The thoughts expressed are those of the author.
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The coronavirus is still spreading throughout China, but all over Wall Street, a consensus about the virus' economic influence is already solidifying.
The thinking goes like this: China will slowly get back to work by the end of the first quarter. Investors will stay fairly steady throughout this period knowing that coronavirus will result only in a temporary knock on corporate profits and general economic activity. Ultimately, like in 2003 when SARS gripped the nation, China will rally to a V-shaped recovery — that is, a quick fall in economy activity followed by a sharp return to normalcy soon after. Markets are overreacting.
This consensus is wrong. And it's wrong not just because we don't know if the consensus timeline is even remotely accurate — but also because the Chinese economy, and especially its banking system, is completely different now than it was in 2003.
The country's economy is growing much more slowly now (GDP growth has recently been about 6%, according to the government, compared with 10% in 2003), and the banking system is far more fragile and laden with debt.
"There's no reference point at all for what it feels like when China is truly in a recession across the board because they've been on a 30-year growth binge," Charlene Chu, a senior analyst at Autonomous Research, said. "The world is underplaying what's going on in China."
Chu described the coronavirus' influence on the economy as a "much deeper shock with a much different context." And in the middle of it all, local governments will still be under intense pressure to meet economic targets, and businesses will be under intense pressure not to fire anyone.
Who will think of the banks?
To understand the economic predicament the country finds itself in, you have to remember what was happening in China about a year ago completely aside from the trade conflict with the US. Last winter, you may recall, it seemed the Chinese economy might come apart at the seams, as credit had dried up for the private sector — which is where most of the country's growth comes from — and consumers dramatically slowed spending.
Then in May, Chinese regulators had to bail out a bank, Baoshang Bank, for the first time in decades. A few more bailouts followed, and suddenly banks became scared to lend to each other. By June, the Chinese Communist Party was forced to gather all the banks, tell them to get their acts together, and demand that they take haircuts on their investments in each other (a concept the bankers had lost familiarity with during the state's post-crisis credit spree).
It is no surprise, then, that the creditworthiness of the Chinese banking system has been trending downward, especially at the lower end.
Because of the coronavirus, this weakened banking system — less than one year out from being on a bit of a brink — will now have to forgive loans for companies large and small and continue financing local governments dealing with the fallout from stagnating economies and the effort to fight the coronavirus. S&P research estimated that if this crisis is prolonged, bad debt in the banking system could increase from 2% at the end of last year to over 6%.
In this environment, some kind of liquidity event could be even more disruptive than it was in the summer.
"Banks will all be more sensitive to their exposure to each other. And they don't really know each other's risk," Dinny McMahon, the author of "China's Great Wall of Debt: Shadow Banks, Ghost Cities, Massive Loans and the End of the Chinese Miracle," told Business Insider. "If there was a liquidity event, you might see a flight to safety very quickly, and how the banks define safety may be a bit more severe than it was last year."
And then, of course, even if the banks could forgive loans and ease credit conditions, that would only do so much. Some businesses simply may not be creditworthy after this economic shock.
"Much of the talk right now is about forcing banks to cut rates, but lower rates won't solve the problem if firms are insolvent," Leland Miller, the founder of the business surveyor China Beige Book, said. "So the issue isn't cost of capital, it's whether the underlying firms are ultimately creditworthy. Depending on how long it takes the economy to get back chugging, that number now may be substantially lower than what it was before the outbreak."
Then there's the private sector
China's other financial-system struggle over the past year was ensuring that private-sector companies, mostly small and medium-size enterprises (SMEs), were getting adequate funding. A lot of these companies used to get financing from China's shadow-banking system, so when authorities cracked down on that in 2017 and 2018, they got squeezed.
Authorities spent last year setting up funding mechanisms for them, but the system still isn't working to perfection. This is incredibly important. Chinese state media reported that in 2018, the private sector accounted for 50% of tax revenue, 60% of GDP, and 90% of new jobs and new firms.
"I think they know they're still going to have an issue getting funding to these guys," Chu said of the SMEs. "They are looking at the bond market ... but they had issues with SMEs and bank problems last summer so that isn't straightforward."
Of course, if you're an SME that has no relationship with a bank, credit relief might not help you much, McMahon told Business Insider.
"This isn't something the banks can necessarily fix, which is new," McMahon said. "You've got a big part of the economy that's sort of out there on its own."
In January, Chinese state media declared China's victory over all of these issues, saying that it defused "the bomb" by taking leverage ratios down at banks. The coronavirus could reverse all of that progress, according to S&P Global ratings, and take leverage ratios up to levels unseen in decades. In these circumstances, the government will need to be very careful about how it manages this situation. This is why China's recovery is going to be a slog, not a snapback.