China’s Leverage Crackdown And What It Means For Stocks

For the last several decades, China’s economy has been growing at an extraordinary clip and now stands as the second largest economy in the world. Inevitably that rate must slow, which is exactly what has happened each year since 2010.

The absolute rate of growth of the economy is a strong point of pride in China, and authorities in the country have historically made it clear each year what they would like to see as the target growth rate. For the last several years, however, that growth mandate may have come at the expense of stability in the economy.

China is unique in that much of the private sector is concentrated in state-owned enterprises (SOE), which can be heavily influenced by government entities. Some critics have argued that these state-owned corporations have been encouraged to take on excessive leverage in order to help prop up the culturally significant gross domestic product (GDP) growth rate. This way, a hard landing would make way for a gradual slowdown. The hard landing has thus far been avoided, but at a cost, as China’s total debt/GDP ratio has soared in recent years, climbing from 194% of GDP in 2011 to 258% at the end of 2016.(1)

Changes Coming from the Top

The Chinese authorities had seemed to largely ignore the growing number of red flags as long as the economy chugged along as desired. However, the past few months have seen a marked change in behavior from the top down.