No need to worry about China's debt bubble...yet

China's debt mountain is massive, and concerns around the sustainability of the country’s credit-fuelled expansion are showing no signs of dissipating.

The world’s second largest economy has certainly had its fair share of bad news recently after Moody’s downgraded its credit rating in May amid fears the nation’s growth rate would slow in the next few years.

Meanwhile, the debt pile has got so big that some speculators think the country is on the verge of slipping into crisis-mode. But should investors steer clear of the region?

While many will err on the side of caution, there are a number of reasons not to worry about China’s debt bubble – for the time being at least.

China’s GDP figures beat expectations after the economy grew at an annual rate of 6.9 per cent in the second quarter of this year, prompting economists to raise their 2017 forecasts. This pushed other emerging markets higher, and reinforced the gains made by commodities exporters.

But the odds of a financial crisis emerging in China over the next two to three years now look pretty slim.

Rather than having piles of debt denominated in dollars, much of China’s debt is held domestically by state-owned enterprises (SOEs).

Erik Lueth, economist at Legal & General Investment Management, points out that, while the banks have less capital and more non-performing loans than they report, the state stands behind them with plenty of creditworthiness.

"With one state organ borrowing from another state organ, rollover risks are greatly reduced,” he says.

Stockpile of savings

Chinese people are also hoarding a lot of cash, meaning the banks are largely reliant on deposits as opposed to risky wholesale funding. The high level of savings also means the financial system is able to sustain more debt.

The credit bubble is one of the biggest concerns for fund managers like Fidelity’s Dale Nicholls, but he points out that the government is actively working to shrink the level of credit. "I really think that there is an increased focus on this, and President Xi Jinping has been very vocal on financial risk.”

Nicholls says that this push is already visible in the numbers as the rate of credit growth seems to be slowing.

Shadow banks

The prominence of shadow credit also continues to haunt China’s financial system, with concerns that this undercurrent of unregulated loans could spark the next crisis.

But Nicholls says this finance sector is also declining significantly, adding: "there’s a definite push to get shadow credit on the balance sheet of the banks.

"Deleveraging is happening, it’s just a question of how fast. I think it’s manageable, bearing in mind the level of liquidity in the system.”

Tricky balancing act

While reducing the debt seems to have taken centre stage, the Chinese government is still intent on maintaining a strong level of growth. These two goals don’t necessarily conflict, but they certainly pose a delicate balancing act for the government, according to Nikko Asset Management’s Woon Khien Chia.

The shift away from credit is likely to impact growth, but it will have a positive effect in the long run by reducing the risks in the economy.

Company clean up

It’s the state-owned enterprises that carry a lot of the debt in China, but Nicholls says investors can’t ignore these companies, particularly in cases where there has been reform. Reform, he says, generally leads to improvements in performance, while a boost to SOE profitability should ultimately create a more sustainable economy.

Compelling companies

Meanwhile, valuations look compelling in China overall compared to other regions around the world, with the price-to-earnings ratio below the US, Europe and the Asia Pacific region, excluding Japan.

"The real story of China over the next five to 10 years is the private companies,” says the Fidelity fund manager. "I think these companies will begin to take share of everything – of the economy, of investment, of employment – that’s the real thrust of it I think.”

Storming ahead

Retail sales in China look strong and disposable income is rising, creating plenty of investment opportunities in the consumer goods and services sectors.

It’s also worth bearing in mind that funds with exposure to Chinese firms scooped up healthy returns last month, with the Investment Association’s China sector topping the best performing league table.

While it might be wise to take a cautious view on China, the crisis that many market players have been predicting seems to be off the cards for the foreseeable future.

Just make sure you monitor how this debt clean up pans out, because you don’t want the market to wipe the floor with your money.