Fewer Loans in China: Impactful, But Perhaps Not In The Way You’d Expect

RESEARCH NOTE

We’ve received a number of inquires, and even concerns, from clients recently about the slowing of loan activity in China. This shift in policy (or at least guidance) and practice has been well covered in the press, albeit with varying level of alarmism, including:

• China Asks Banks to Curtail Credit for Rest of Year (Bloomberg)
• China Credit Impulse Set To Collapse As Beijing Orders Banks To Curtail Loan Growth For Rest Of 2021 (ZeroHedge)
• China asked banks to rein in credit on bubble fears, FT reports (The Straits Times)

I’d like to share our perspective on the topic and what I think it means for Chinese equities. In short, I expect any deleveraging will be very modest, targeted, and carefully applied. The implications of this will likely be a sector and style rotation versus a broad equity market sell-off. Here’s why:

Bank stocks. First, from the perspective of banks, this is probably on balance a good thing, since for the last year they’ve been politely “asked” to lend excessively to support the real economy. Policy change along these lines will reverse that trend, and we’ll start to see the massive bad loan reserves on banks’ balance sheets that’s been weighing on current asset quality—NPL went up from 1.21% to 1.33% over the course of 2020—start to improve. In that sense, the whole sector will start to look “less state-owned” and more profitable. Along the same lines, if credit becomes tighter, we should also see the Net Interest Spread (NIS)—which is incidentally something we take into account when valuing Chinese banks—begin to widen, since lending rates are more elastic than savings rates. That will tend to boost banks’ margins, too.

Tech stocks. Slower loan growth will be bad, on the other hand, for China’s tech names. There are two channels here. First, Broker margin and the still-substantial shadow margin lending market will both contract, which puts a curb on speculation, and we know speculative trades tend to be concentrated in the tech sector. Tightening of margin and increased cost of shadow margin will hurt through that channel. Second, most Chinese brick-and-mortar firms with a decent balance sheet were forced to borrow (since those SOE banks were forced to lend), and a lot of that money went into the best-performing funds—which, of course, were thematic tech funds. So there will be selling in those funds, as well.

Targeted approach. One thing to note is that China’s tightening will be more targeted than what we usually see in the US. The Chinese government controls various state-sponsored investment funds, which also have massive lines from SOE banks and invest heavily into strategic sectors—which have lately been 5G, semiconductor, biotech, vaccine, etc. When China’s regulators think there’s a bubble brewing due to too much credit, the government tends to take a targeted approach, going after broker margin, shadow margin, and investments in specific industries, for example. So in this sense, the most overheated themes will be most affected.

Real Estate. The impact on real estate will likely be significant. Over the past six months, despite policy designed to limit real estate firms expanding their liability (the so-called “Three Red Lines”), as well as constraints applied to banks on household mortgage writing and lending to real estate firms, 1Q21 saw 86% YoY growth in real estate sales and 38% YoY growth in real estate investment. That tells us both banks and real estate firms are finding workarounds for lending/borrowing which led the PBOC to reemphasize deleveraging. On the other hand, we know the Chinese government is more sensitive to real estate prices declining than rising, so policy to cool off real estate will only be administered insofar as it prevents crazy price increases—not used to destabilize prices.

Quality vs. Junk. As mentioned before, the frothiest pockets of the market are most susceptible to feel the pain from credit tightening. Likewise, most of the low-quality names in China that have risen in the last year’s rally are companies supported by regional governments. Consequently, when the pullback on easy money happens—and it will likely be accompanied by increased scrutiny—the credit crunch should concentrate on these low-quality names, leading to relative outperformance of quality factors (of which our strategy employs a great many).

Again, our past experience tells us that any broad deleveraging will be very, very modest and very, very careful. We can also assume that the current deleveraging will be much more targeted than before. What this means, as you can probably gather from the bullet points above, is that we expect more of a sector and style rotation than a broad sell off of the equity market.

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