Rising corporate debt emerging as major risk

It's evident the recovery since the start of 2016 is unsustainable and lacking a broad-based impact on the economy

Broadly speaking, we expect economic activity in May to remain similar to April and continue to draw on the momentum seen from the massive government stimulus since late last year and the beginning of this year. This consists mainly of resilient infrastructure and real estate investment.

Despite the slowdown in April, we continue to expect infrastructure investment to remain relatively strong on the back of the sharp increase in newly approved projects at 38 percent year-on-year. Indeed, the National Development and Reform Commission, the economic planner, said in May that between 2016 and 2018 a total of 4.7 trillion yuan ($715 billion; 629 billion euros) will be invested in 303 transportation-related infrastructure projects, thus providing a steady flow of new projects to keep investment strong.

In addition, the People's Bank of China said on May 3 that it is encouraging policy banks to use pledged supplementary lending for financing these long-term projects.

The property sector, driven by looser lending policies, also remains a pillar for the economy. From January to April, housing sales increased by 61.5 percent year-on-year in 70 cities, along with surging prices, first among top-tier cities and then more recently in smaller cities. It has brought back the enthusiasm of property developers to invest in construction projects. Real estate investment picked up to 7.2 percent year-on-year from January to April.

Nevertheless, it is already evident that the recovery since the start of this year is unsustainable and lacking a broad-based impact on the economy. The private sector, in particular, was generally left out of the government's stimulus program. Private fixed-asset investment weakened to 5.2 percent year-on-year from January to April. Manufacturing investment also slowed to 6 percent year-on-year.

This shows that the rapid credit growth has largely benefited the cash flows of the already highly indebted real estate sector and government-related parties.

For external trade, we do not expect much improvement from the lackluster global demand that has been the prevailing theme in both the International Monetary Fund and the China Customs' assessment. Specifically, high-frequency updates from the shipping industry suggest that demand from both the United States and Europe has been mild, which has led to delays in price hikes.

Therefore, we expect exports to fall further by 5 percent year-on-year in May, and imports by 6 percent year-on-year, although the trade surplus will again expand to $57.2 billion amid an even worse decline in imports.

Last, we believe the tightened loan growth in April was a correction from the radical monetary easing in the first quarter. Although monetary easing may become less aggressive, especially as it has become the focus of internal policy disagreement, credit growth in May will likely expand moderately again. Meanwhile, corporate bond financing will likely tighten further amid rising credit risk.

Going forward, we expect the massive stimulus that has so far prevented a further economic downturn in China to scale down, particularly as monetary policy may become less accommodative.

Altogether, we believe China's economy and its policy position are both at a crossroad, and further moderation in China's outlook is likely inevitable in the coming months.

We see two major risks for the Chinese economy now: further RMB depreciation, due to US dollar strengthening, and corporate default.

Appreciation of the dollar since May could reflect the impending US Federal Reserve rate hike, which has already caused the RMB to weaken. In fact, the US rate hike cycle has historically been destabilizing to financial markets around the world. Again, we believe RMB depreciation is sending a message that the expected June interest rate hike by the Fed will likely have negative repercussions for the global market.

Even though we maintain our view that a massive one-off devaluation of the RMB is unlikely, mild depreciation of the RMB is the most likely scenario, at least until the third quarter.

Indeed, easy access to credit may have contributed to the excess capacity and rising debt burden of the state-owned enterprises. The discussion between the State Council and the Central Leading Group for Comprehensively Deepening Reforms in May highlighted that there are 345 "zombie" SOEs, many of which also have multiple subsidiaries and complicated management hierarchies.

Although there are only 106 central government-controlled SOEs, there are altogether more than 40,000 business entities under them, which harbor redundant labor and excess capacity. The commitment to remove these obsolete resources, in our view, is an important part of China's SOE reform.

Subsequently, the rapidly rising corporate debt-to-GDP ratio has become one of the most serious risks facing the Chinese economy. This could be attributed to:

Diminishing marginal return of capital in recent years, partly on the back of corporate inefficiencies.

The rising financial investments of nonfinancial companies.

Zombie companies need more loans to pay back their debts. We noticed that with the slowing down of the economy, the number of A-share-listed nonfinancial companies with earnings insufficient to cover their interest payments has grown dramatically to 425 last year from 272 in 2013. Without decisive reform, this problem could only get worse.

Shen Jianguang is chief economist at Mizuho Securities (Asia) Ltd and Michael Luk is a researcher with the same company. The views do not necessarily reflect those of China Daily.