abc Global Research Local debt, financial risk and a shrinking labour pool pose tough challenges But concerns that these problems will choke off growth are overplayed We remain bullish on Chinas growth story in the years ahead Economic growth in China accelerated for the first time in two years in 4Q12. GDP expanded 7.9% y-o-y, up from the three-year low of 7.4% in 3Q12 and in line with our expectations. Despite the gloomy outlook for global demand, we stick to our above-consensus forecasts of 8.6% for this year and 8.4% for 2014. But dont get us wrong. The reason we are so bullish is not because we dont see the challenges that lie ahead. While there is a long list of problems, some serious, we believe practical solutions are available which can avoid systemic risk that could put a chokehold on the China growth story. This report looks at three key structural problems: Local government debt is increasing too quickly and needs to be reined in. But at around 23% of GDP, the overall level of local debt is still manageable (total government debt stands at 54% of GDP). Unlike in Europe, 70% of the loans have been invested in infrastructure assets, most of them useful, so local government balance sheets are not in as bad shape as many think. The duration mismatch between repaying the loans and generating returns needs to be addressed but Beijing has three feasible options. Financial risk: We share market concerns about shadow banking but talk of a credit bubble is an exaggeration; the regulator is keeping an increasingly close eye on this issue. The credit-GDP ratio is high but this is the result of the under-development of the bond market and the ongoing monetisation process. Demographics: The working age population has started to shrink. Yet the impact on the potential growth rate is marginal because it is labour productivity rather than labour pool expansion that really drives growth. There is still plenty of room to lift productivity by shifting rural labour to more productive urban sectors. Macro China Economics China Inside Out Structural problems, practical solutions 28 January 2013 Qu Hongbin Chief China Economist The Hongkong and Shanghai Banking Corporation Limited +852 2822 2025 hongbinquhsbc.com.hk Sun Junwei Economist The Hongkong and Shanghai Banking Corporation Limited +8610 5999 8234 junweisunhsbc.com.cn View HSBC Global Research at: http:/www.research.hsbc.com Issuer of report: The Hongkong and Shanghai Banking Corporation Limited Disclaimer this quota was raised to RMB250bn in 2012 from RMB200bn; 2) a pilot programme allowing four provinces to issue bonds directly; and 3) local government financing vehicles issuing corporate bonds (城投债 in Chinese), which saw a 148% y-o-y increase in annual issuance in 2012. Demand for bond is not a problem, given that Chinese households have over RMB41trn in savings deposits. Selling government assets. As we argued early, local governments have a great deal of financial muscle to help them fend off solvency risks. The assets they own include the infrastructure projects, land and over 20,000 state-owned enterprises (SOEs). Selling publicly-owned assets either through public listing of SOEs or securitisation remains an option to help pay off debt. In our view this would also help to shift the focus of local governments away from business and back to public services a key objective of government reforms in the next five years. Better tax split. Giving local governments a bigger share of tax revenues would significantly strengthen their fiscal position. At the moment the central government takes nearly 50% of tax revenues, with local government getting the balance, although the central government does make fund transfers afterwards. (Local governments used to get 6 Macro China Economics 28 January 2013 abcaround 40% until the system was changed in 1994.) This issue is likely to be addressed by the new leadership. The reforms will likely rebalance revenue sharing and probably expand the pilot schemes that allow some local governments to collect property tax and VAT. 2) Financial system risk The market has expressed concerns about risks related to Chinas financial system. They include a high credit-GDP ratio, exposure to the property market and the shadow banking system. How serious are they? High credit-GDP ratio The credit-GDP ratio, as measured by M2 to GDP, reached 188% at the end of 2012, up from 151% in 2008. This is indeed much higher than many other countries but before talking about the risk of a credit bubble we need to consider the following: Chinas economy is going through a process of monetisation, also known as financial deepening. It is quite unlike what is happening in the West, where money is being printed to resolve debt problems. Rather, it means that apart from facilitating normal economic activity, extra sup