From BlackRock: China’s stabilizing growth has eased some of the anxiety that rattled investors in early 2016. But it is partly the result of returning to an old habit. Isabelle Mateos y Lago explains.

China’s stabilizing growth has eased some of the anxiety that rattled investors in early 2016. But it is partly the result of returning to an old habit: hefty lending to national and local state-owned enterprises (SOEs). China’s private debt-to-gross domestic product (GDP) ratio has surged to more than 200%. Never has a big economy piled up so much debt so quickly, as the chart below and related interactive graphic show.

Credit binges in the past often led to busts. Yet China is different in some ways. Thanks to its large domestic savings rate, it has little external debt—the original sin that has sparked many emerging market (EM) crises. Beijing is working on fixes for internal debt issues, such as turning short-term bank debt into long-term bonds and redirecting credit to the private sector and households. But ultimately, China needs to find more sustainable engines of growth beyond further debt accumulation by unproductive national and local SOEs, or accept slower growth.

This is a difficult balancing act: The longer China delays attacking the problem head-on, the greater the risk of accidents.

Rising global rates and a stronger U.S. dollar are creating additional challenges for China. They are leading to capital outflows and a drain on reserves, as the central bank tries to resist downward pressure on the yuan. This is contributing to higher local interbank rates, which can hurt growth over time.

Speculation may build that authorities will allow a one-off large currency devaluation to stem capital outflows. This would likely have knock-on effects on other EM currencies and asset prices. We expect a further gradual decline in China’s currency against the U.S. dollar in 2017, but a large devaluation is not our base case.

We are on the lookout for any signs of stress such as greater capital outflows or disruptions in China’s fixed income markets. Increased trade frictions would also intensity the risk to our outlook for China and EM assets in general. Read more in our 2017 outlook.

iShares FTSE/Xinhua China 25 Index (ETF) (NYSE:FXI) fell $0.10 (-0.28%) in premarket trading Friday. Year-to-date, FXI has gained 3.77%, versus a 1.28% rise in the benchmark S&P 500 index during the same period.

FXI currently has an ETF Daily News SMART Grade of B (Buy), and is ranked #1 of 32 ETFs in the China Equities ETFs category.

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This article is brought to you courtesy of BlackRock.

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