China has started deleveraging since the beginning of this year, which is considered as tapering by most people. The stock market has thus suffered a heavy sell-off.
Why deleverage? It’s because the corporate sector – state-owned enterprises, in particular – have borrowed too much.
There is nothing wrong with deleveraging; the problem is that such a move is hurting private companies more.
State firms are still able to obtain capital, and their borrowing costs have not gone up a lot. Yet private firms’ access to capital has become much more restricted, or even cut off in some cases.
Private firms, in fact, are the most dynamic and innovative segment of the economy. If their condition deteriorates, the overall economy will be in trouble.
In the wake of global financial crisis, the US Federal Reserve did not push for deleveraging right away to rectify the situation of excessive gearing.
The Fed knew well that banks and those who have borrowed subprime mortgages had high leverage levels, and if it kicked off deleveraging immediately, the economy would almost certainly experience a hard landing.
Instead, the US central bank launched the quantitative easing program to bring down interest rates in order to ensure that debtors won’t go bankrupt. Also, it has tightened regulation over banks and asked them to raise capital adequacy and reduce leverage.
Eventually, the economy turned around, and most debtors were able to pay off their debt, achieving what billionaire investor Ray Dalio described as “beautiful deleveraging”.
Debt borrowed by corporates and individuals was essentially transferred to the balance sheet of the Fed, which then started to deleverage with quantitative tightening moves in recent years.
Deleveraging has to be conducted in a low-rate environment since high rates would weaken the capability of debtors to repay their debt. High capital costs would also stifle economic growth.
Luckily, China seems to have noticed the problem and decided to inject liquidity to stabilize the credit crunch.
China’s economy is already recovering. If the US-China trade relationship does not get notably worse, mainland stocks will start looking attractive at current valuations.
This article appeared in the Hong Kong Economic Journal on Nov 26
Translation by Julie Zhu
[Chinese version 中文版]
– Contact us at [email protected]