China won’t cut its debts or fix its industries — but that’s OK, says Pimco’s Asia guru

So it was somewhat counter-intuitive when the veteran Pimco portfolio manager told CNBC the country’s high level of debt — the main source of concern among investors — isn’t primed to go away anytime soon.

In fact, he said, borrowings may even increase significantly.

And it’s not just debt growth that won’t get better in the world’s second-largest economy, according to Spajic, who manages the bond giant’s Asian credit portfolios and leads the emerging markets portfolio management in Asia — overseeing an estimated $8.6 billion worth of assets in the region.

That is, China’s efforts to restructure its massive and debt-ridden state-owned enterprises may not make much headway despite a push from Beijing to contain domestic financial risk, he said.

“When we scratch the surface, we don’t expect to see any major macro deleveraging in China. There’s still going to be significant debt growth in China. The composition may change but it’s not going to be shrinking,” Spajic told CNBC.

“Second of all we don’t expect transformational reforms. SOE (state-owned enterprise) reform will be a hard nut to crack though there may be some M&A (mergers and acquisitions), the government may shift around what they do slightly, but there’s going to be no big transformation there, either. It’s likely to be incremental,” he added.

But Spajic quickly dispelled doubts about his place in the optimist camp, following up with this point: China’s increasing debt is less of a worry if growth continues to outpace borrowing costs.

With China’s economy expanding at 6 to 6.5 percent and inflation at 2 to 3 percent, its nominal growth rate adds up to 8 percent and above, he explained, noting that’s higher than the 5 to 6 percent interest rate that companies have to pay on their debt.

“If companies are robust, they would be able to grow into their debt load and to pay back interest quite comfortably. Now obviously, if you’re a company that is growing at 2 or 3 percent, then you’re going to struggle,” he said. “The debt load is sustainable if the macro growth numbers hold up, but will be at risk in a hard landing or a major financial disruption.”

Things could still go wrong in China
China has long relied on debt to drive economic growth, but leverage has grown to levels that worry much of the global investment community. Two major global ratings agencies, Moody’s and Standard & Poor’s, downgraded the country’s credit in May and September, respectively. Their peer, Fitch, warned that China may see its first local government bond defaults.

Bad loans held by Chinese commercial banks amounted to 1.67 trillion yuan ($253 billion) as of September 2017, increasing by 34.6 billion yuan ($5.2 billion) from the previous quarter, according to official statistics. But some estimates are much higher, according to Spajic.

A number of forecasts, he said, put China’s bad debt at between 6 and 12 percent of bank balance sheets. That is equivalent to between 10 and 20 percent of GDP or between $1 trillion and $2 trillion, he added.

That is the price of the Asian giant’s economic successes, so Beijing’s handling of the debt build up will have “meaningful consequences,” said Spajic. One of those consequences could come from the currency: If China decides to cut rates and let the yuan weaken to make debt more affordable, other countries could suffer from their currencies growing too expensive.

Deflation can hit demand as consumers tighten their purse strings and companies pull back on investments in anticipation of falling prices, hurting the economy in the process. A policy mishap in China is therefore one of the three key risks Spajic said he is watching, along with the North Korean situation and President Donald Trump’s trade intentions.

Another consequence of Beijing mishandling domestic debt could be companies defaulting on their loans. In such an event, the value of assets that can be recovered is likely to be low, he added: “If a company goes bust in China, it means it probably doesn’t have much political connectivity. They’re just not favored.”

But the portfolio manager’s “strong view” is that the rate of defaults in China will be lower than western standards in the foreseeable future. It is also important to note that the country’s debt situation is largely a “family affair” where “you have government-owned companies borrowing from government-owned banks,” Spajic said.

“In a way, the ultimate owner is on both sides of the balance sheet. This is quite unique because the owner is a government that is steered by party principals and by the collegiate effort to do what is right for China,” he said. “The bottom line is that they probably have an ability to resolve things more quickly with like-minded people that are around the table.”

Asia’s story goes beyond China
Spajic, who hails from the U.K., took up his current role and moved to Singapore in 2014. Before that, he headed the firm’s European credit portfolio management.

Despite his “relatively limited” experience investing in the region, Morningstar said Spajic’s “investment process is sensible.” A fund he manages, the $41.5 million Pimco GIS Emerging Asia Bond, returned 4.22 percent on an annualized basis between June 2016 and September 2017 — under-performing its benchmark by 60 basis points, the research firm noted.

“However, we note that it is still early days and would like to see Spajic build his track record on this fund,” Morningstar’s research analyst Don Yew wrote in a report.

For the newly-minted Asia guru at Pimco, there couldn’t be a better time to be in Asia as the region’s strong growth story extends beyond China. India, for instance, is a country with high growth, high rates and a stable currency that is attractive to fixed income investors, said the portfolio manager.

Over in Southeast Asia, Indonesia’s climb into investment-grade status has attracted “much more international investor interest,” he added. And more optimism could come Asia’s way, partly thanks to China, but also due to the general uptick in prospects across emerging markets.

“From a capital market standpoint, there are many stories that are evolving around Asia: China being one, India being another, Indonesia being third. They offer an eclectic mix of opportunities in currency, dollar debt, local debt and equity,” Spajic said.

“They’re big, somewhat scalable and very interesting. Other countries will benefit from that broad interest in Asia, such as the Philippines, Malaysia — even less well-followed countries like Vietnam. Let me put it this way: You’ve got 60 percent of the world’s population driving 60 percent of the world’s incremental GDP growth, and likely to issue 60 percent of the world’s debt over the next decade. That’s a pretty phenomenal story to be building an asset management effort on.”
Source: CNBC

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