China’s economic challenges have never been more pressing, and for that reason, PIMCO’s forecast for the official growth rate this year is below consensus at 5.5%-6.5% and below China’s own target of 6.5%.

In arriving at our forecast, we focused on four major headwinds to growth.

• Leverage. Since 2007, China’s economy has added over $21 trillion of debt – more than one-third of the world’s debt. However, the amount of growth that each new dollar of debt is generating has been declining, such that if nominal GDP expands close to the government’s target this year, then China will need to add a minimum of 15% of debt to GDP. So leverage will continue to rise, but its ability to generate new growth is diminishing.

• Non-performing loans (NPLs). In China, the reported NPL ratio stood at 1.4% at the end of 2015, and we think that will trend up over the next three to five years. Under our baseline forecast for growth, PIMCO’s internal stress tests of China’s banks suggest that the NPL ratio could peak at about 6%. Under a more stressed scenario, a recapitalization of the banking system would be required, but we view this risk as a longer-term risk, well beyond this year. NPLs are a manageable and well-flagged long-term problem, and while we do not expect a dramatic injection of capital into the banking system over the coming year, we do believe the problem will continue to restrain the transmission of policy.

• Property market. We expect property investment to continue to be a drag on growth, but prices overall will likely end the year in modestly positive territory. Although the property market holds a special place for policymakers in China, especially the People’s Bank of China (PBOC), it remains a worry and is unlikely to be a driver of growth near term.

• Equity market. By market capitalization, China has the second-largest equity market in the world. Following the bursting of the bubble last year, policy experiments and interventions in equities have failed, and the regulator, the China Securities Regulatory Commission, is now under new leadership. Against this backdrop of volatility, Chinese securities are expected to enter the MSCI EM index later this year.
Of these four drivers, the property market perhaps generates the widest concern, but in our view, equities will be hardest to control.

Although China still has policy options to stimulate growth – cutting interest rates and reserve requirements and undertaking fiscal policy efforts – there is serious risk of diminishing return per unit of policy impetus, in part because the currency is now a major constraint on policy. China is facing a “trilemma” in that it is proving impossible to achieve three goals at the same time: a stable or fixed foreign exchange rate, free capital movement and an independent monetary policy.

Luke Spajic is an executive vice president and portfolio manager in PIMCO's Singapore office.