Concerns on balance sheet weakness unfounded. China equities have given up earlier gains and stayed flat year-to-date, a stark contrast to the 16% return recorded by global equities and 7% by Asia ex-Japan peers.

Of late, there have been comments alluding to China becoming like Japan, post the latter’s property bubble burst in the late 1980s. Japan underwent what some have dubbed a ‘balance sheet recession’ and spiraled into a ‘lost decade’ with stubborn deflation for the next 25 years.

‘Balance sheet recession’ is a consequence of post-bubble asset price collapse. As it unfolds, companies will pivot from profit expansion to debt reduction. This results in the shrinkage of demand for bank loans, growing reluctance of companies and consumers to invest and spend. This creates a prolonged spiral down effect on economic growth, business profitability and consumer confidence.

Against this backdrop, some market watchers have begun to discuss the risks of China falling into a similar situation. We believe the case is otherwise.

Unlike Japan which made policy flip-flops post the property bubble burst, coupled with a lengthy deflation that diluted the effects of monetary and fiscal supports, and a strong Japanese yen in the 90’s that hit exporters hard, China’s economy and corporate sectors operate on an entirely different footing.

We believe China will not slip into ‘balance sheet recession’ on the following grounds:

1. There is credible ability for the central government to make decisive policy moves.
2. The depth of corporate balance sheets and domestic consumption will continue to support investments and end demand.
3. Unlike Japan which relied heavily on its real estate sector, China’s GDP composition is evenly spread, with industrials accounting for 33%, wholesale and retail trade at 10%, and financial services and agriculture both at 8%. Construction and real estate account for a mere 7% and 6% respectively.
4. China’s financial system is armed with ample liquidity and healthy levels of household savings.
5. New growth drivers are expected to chart the new course over the next decade – the new energy sector, digital transition wave, middle-income spending, and urbanisation.

In this report, we look into the demand for loans, revenue trends, and earnings quality among China corporates. While markets have speculated the likelihood of ‘balance sheet recession’ stemming from corporate sectors, we believe the likelihood of China following in Japan’s footsteps is low, as the demand for financing remains strong (Figure 1). The cumulative outstanding total social financing (TSF) has sustained the demand momentum – it was up 21% in the first half of this year compared with the same period in 2022.
Anecdotal evidence shows that loan growth stays robust. The banking sector’s total loan outstanding rose to new high of CNY230t in June while new loan growth stayed above 11% on a year-on-year basis (Figure 2). Loan growth is projected to persevere at current levels, indicating business and household borrowers remain optimistic in expanding their balance sheet, as opposed to what some market watchers have opined.

Figure 1: Total social financing continues to expand

Source: Bloomberg, DBS

Figure 2: Loan growth keeping pace

Source: Bloomberg, DBS

Income streams unscathed by economic volatility Another fundamental factor that supports our view on sustainable loan demand and balance sheet expansion is the prevailing revenue stream and stable cash holdings among China corporates (Figure 3). China corporates have proven their ability to achieve revenue stability through the pandemic and economic cycles over the past few years. This adds on to the propensity in the expansion of businesses through bank financing.
Another indicator we examine is the free cashflow yield which reflects the ability of firms to generate actual income from their day-to-day operations. After hitting a low of 3-4% during the pandemic, free cash flow yield has well recovered to 7% (Figure 4), nearing the level last seen in 2017.
Hence, corporate sectors will remain confident in expanding their businesses, and continue to tap financing pipelines to increase leverage and drive shareholder returns.

Figure 3: Revenue unscathed by economic cycles

Source: Bloomberg, DBS

Figure 4: Free cash flow yields improving

Source: Bloomberg, DBS

The shrinking of exports, declining industrial profit growth, and weaker-than-expected quarterly GDP reading (Figure 5) and low confidence (Figure 6) should work towards prompting the government to work on new policy implementations.
We believe policymakers will pull all the stops to prevent a striking divergence between economic targets and actual readings, rolling out effective stimulus measures to improve the sluggish momentum.
As such, we do not expect the massive engine of growth in China’s economy to grind to a halt. Rather, the commitment to support growth will persist, with more emphasis placed on strategically important areas, such as inspiring domestic spending, policy support for private sectors and platform conglomerates to raise investments, jobs creations to address youth employment issues, and green energy development.

Figure 5: Improvement of industrial profits and GDP growth

Source: Bloomberg, DBS

Figure 6: Free cash flow yields Figure 6: Confidence bottoming

Source: Bloomberg, DBS

As global demand slows and knowing that it can no longer rely solely on export driven growth, China’s policymakers will look more inwardly to strengthen local industries by promoting the creation of domestic champions and businesses. A successful policy implementation will bring multi-faceted benefits – stimulating GDP growth and investments, strengthening corporate earnings and creating jobs sustainably, just to name a few.
China’s party central committee and the Premier-led State Council recently announced a joint declaration to fortify the operating environment for private sectors. In the ‘Opinions of the Central Committee of the Communist Party of China and the State Council on Promoting the Development and Growth of the Private Economy ‘ released on 19 July, the authorities highlighted 31 policies to support the development of private sectors and companies.
This move was widely seen as the authority taking steps to galvanise confidence to fend off slowing economic growth. One essential narrative was to treat private enterprises to be on par with state-owned entities, support the former in overseas ventures, initial public offerings, as well as fund raising.
The valuation of China equities currently hovers at -1 standard deviation to mean (Figure 7), indicating the markets have priced in low expectations on the outlook. We think this is unjustified given the list of fundamental factors supporting the long-term developmental routes. As such, we assert our constructive views on China.
On the income side of the CIO Barbell Strategy, stay invested in large state banks which reward shareholders with stable dividend yields of 8%. On the growth side, we favour the secular trends of digital platform sector, green energy transition, digital transformation, insurance penetration, and local A-shares.

Figure 7: Valuations are undemanding

Source: Bloomberg, DBS