China meltdown `very unlikely’: Lombard Odier

By Francis Acosta

Added 21st November 2016

China’s debt-to-GDP increased to 250% in the first quarter this year from 154% in 2008. But Lombard Odier believes the picture is not as bad as it seems.

China meltdown `very unlikely’: Lombard Odier

The development of a huge shadow banking sector has added concerns that these unregulated activities could worsen underlying credit problems within the banking system and generate systemic risk.

But the likelihood of a financial meltdown is “very unlikely” over the next two to three years, according to a research note from Lombard Odier (LO).

China’s strong external balance sheet, capital controls and healthy trade balances provide a counterbalance to the financial meltdown scenario, the firm said.

In addition, putting China’s debt problem into context, its current debt-to-GDP ratio is still low compared to Japan (388%), France (290%), Canada (288%), Italy (275%) and the UK (266%), according to a separate Matthews Asia report.

China’s “key differentiating economic factor” is its position as creditor to the world, according to the Lombard Odier report. It is the world’s third largest supplier of external capital.

In addition, external assets also remain predominantly in very liquid US debt securities, including foreign exchange reserves of around $3.2trn.

The high savings rate of the population also helps China deal with debt, according to the Matthews Asia report. China’s gross savings as percent of GDP stands at 49%, the report says, adding that the nation’s household savings is more than the combined GDP of Brazil, India, Russia and Italy.

Strong capital controls

In China, the “very high level” of broad money (M2), or assets that can be quickly converted into cash or checking deposits, is often cited as a key weakness, the LO report said. 

“The main worry is a scenario wherein the domestic capital represented by M2 were to leave the country,” the report reads. “It would put China’s foreign exchange reserves under severe pressure, as capital outflows exceed the current account surplus.”

However, China has employed capital controls that have prevented the risk of domestic capital flight.

For example, China suspended in February new applications under the Renminbi Qualified Domestic Institutional Investor (RQDII) programme, which allows yuan from the mainland to be used to buy offshore securities denominated in the currency. Since March, it has also refrained from granting new quotas for residents to invest overseas via the QDII programme.

China also halted its  qualified domestic limited partnership (QDLP) programme in March, and is expected to stay that way until mid-2017, according to a Reuters report. The QDLP programme allows firms to raise renminbi from wealthy and institutional investors to invest overseas.

Service sector growth

Lombard Odier also believes that longer term, there are specific investment opportunities in China, especially in the absence of a financial meltdown scenario.

“We believe the structural changes that are underway in the country are yielding promising ways to generate returns from the growth of the service sector,” the report reads.

Opportunities are seen in e-commerce, telecommunications services and travel sectors, according to the report.

For example, it is estimated that the online shopping market will reach above the RMB6trn ($870bn) mark in 2017, which compares to RMB3trn in 2014.

Meanwhile, travel services are another opportunity. The market has grown to around $155bn, but only about 8% of China’s population has travelled as tourists, according to the report.

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