The global financial community is almost uniform in its scepticism about China, which is rooted in the perception that China has four major economic problems, which will guarantee the long-awaited hard landing of the Chinese economy. China’s most serious problem, the narrative goes, is debt. The debt load is so excessive that China’s economy is slowing. 
The slowdown in growth in turn explains why the stock market is so beset with volatility and frequent speculative frenzies. Finally, all the aforementioned problems in turn give rise to the final problem: terminal capital flight. Since all the problems are interlinked, but ultimately rooted in the debt problem, which, everyone knows, is notoriously intractable it follows that China’s outlook is permanently bearish.
We disagree with this narrative. We do not accept that China has a fundamental debt problem to begin with. We do not believe that the other three problems are linked to debt. We do not even see China’s alleged ‘problems’ as necessarily problematic, because they are mostly symptoms of other developments many of which are actually fundamentally positive. We now explain these views:
Debt
China’s debt stock is large compared to other emerging market (EM) countries. China’s stock of domestic credit to GDP is 256 per cent of GDP. While this compares favourably to the 290 per cent credit to GDP average for developed economies it is nevertheless noticeably higher than the 155 per cent average for EM countries ex-China. However, it makes no sense to look only at the lending side without also looking at the funding side.
In China, the stock of deposits to GDP is truly massive: 197 per cent. This means that the banking system is only leveraged to the tune of 30 per cent (equal to 256 per cent divided by 197 per cent). The high level of deposits is a direct consequence of China’s enormously high saving rate (49 per cent). With such a high savings rate even if China’s banks used zero leverage they would still extend credit worth nearly 200 per cent of GDP.
The high level of deposits is actually a strength: deposits are the single most stable source of funding for banks. Moreover, China’s banks have extended most of their credit to infrastructure investment, which is likely to offer a higher return over the long term than, say, consumer loans in Western banks. Finally, China’s debt stock is entirely sustainable given current growth and interest rates. In sum, debt is not a systemic problem and should therefore not be regurgitated endlessly as the source of China’s alleged economic problems.
Slower growth
If debt is not the problem why is China’s growth rate slowing? The primary reason for slower growth is that China is implementing an extremely ambitious reform programme. The reforms include interest rate liberalisation, price liberalisation and capital account liberalisation. They are part of a broader reform programme designed to rotate the entire economy away from state control to market forces and away from an export-led focus towards a domestic demand-led growth strategy.
The magnitude of these reforms is such that consumers and investors have become far more cautious pending better information about the success (or otherwise) of the reforms. The postponement of investment and consumption is the principal reason for slower growth. Investors should not be overly concerned, however.
China’s reforms are the right ones and are very likely to succeed. Longer-term, China will naturally grow more slowly, since a consumption led growth model implies lower savings, lower investment and therefore lower real GDP growth rates. However, consumption will rise, so there will not political unrest.
Stock market volatility
Chinese retail investors tend to invest in two types of assets (other than cash): property and equities. Both are bull-market instruments. There is no obvious bear market instrument such as bonds available to retail investors, because nearly all the bonds in China are held by banks, pension funds and other institutional investors. Where, in fully developed financial markets, investors would switch into bonds in China the only way to trade a bear market is to sell stocks…and then to sell them again, that is, to short sell them. China’s stock market therefore tends to generate twice the volatility of developed economies with more broadly held fixed income markets.
Broadening the ownership structure of bonds in China is an important policy objective and China is making strides in this area with the development of the municipal bond market and rolling out mutual funds. Soon China’s onshore bonds will also feature in the most important global bond indices. For now, however, it should be recognised that the volatility in the Chinese stock market is more a reflection of an underdeveloped fixed income market rather than a symptom of some deeper macroeconomic malaise.
Capital flight
Chinese investors are infinitely better informed about the rest of the world than the rest of the world is about China. While Chinese investors have the same home biases as investors in other markets, which means that their investments will always predominantly be domestic they are nevertheless ready immediately to allocate some of their savings to foreign assets. 
With the exception of foreign central banks, which are already invested onshore in China other institutional investors overseas have generally not yet allocated to China, especially not commensurately with the size of the Chinese market.
One significant obstacle to further foreign involvement is that China’s onshore stock and bond markets are not yet represented in the main benchmark indices. This gives rise to a stark asymmetry between Chinese appetite for foreign assets and foreign appetite for Chinese assets, which in turn poses a problem for China’s reformers at a time of capital account liberalisation: for a time at least outflows will be larger than inflows. This pressure should ease, however, as China is included in the main indices and until that happens it seems likely that China will only gradually relinquish capital controls if only to ensure an orderly liberalisation of the capital account.
In conclusion, China’s growth is slowing due to reforms, not excessive debt. Stocks are volatile due to a combination of large volumes of savings and inadequate access to both bonds and foreign assets. China’s reforms are the right ones and the debt stock is sustainable. There is no reason to expect a hard landing. China’s growth rate will continue to slow as consumption gradually becomes the dominant driver of the economy and savings rates decline.
China’s financial markets will continue to deepen and, as they become more integrated with global markets, will also become more stable. Finally, as Chinese savers will gradually get their fill of foreign assets and as foreigners are brought into China on the back of index inclusion so the capital flight ‘problem’ will fade way.
Jan Dehn is head of research at Ashmore. The views expressed above are his own and should not be taken as investment advice.