An unbearable weight
China’s spiralling debt cannot be sustained

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Denizens of the Great Southern Province of China (otherwise known as Australia) are increasingly concerned about the Middle Kingdom’s economic problems, which may affect their prosperity. Central to these is a rapid increase in debt levels.

China now has higher levels of debt than the US, Germany or Australia. Between 2007 and 2014, China’s total debt quadrupled, from US $7 trillion (158% of GDP) to US $28 trillion (282% of GDP). In 2002, total Chinese debt was US $2 trillion (121% of GDP). Since 2007, China has contributed around one third of the total increase in global debt.

Casus belli

The 2008 global financial crisis and the resulting synchronous recessions in the developed world exposed China’s economy, especially its export sectors, to a large external demand shock, slowing growth. Beijing deployed massive resources to restore growth to counter the economic and social impact of the slowdown.

Modest fiscal measures were augmented by a significant expansion in credit (known as total social financing, or TSF, which covers a mix of loans, bonds, bills and even some equity financing) via the large policy banks, which are majority government owned and controlled.

Since the GFC, new lending by Chinese banks has been consistently around 30% or more of GDP. Around 90% of this lending was directed toward investment in building, plant, machinery and infrastructure, especially by state-owned enterprises (SOE). According to the World Bank, almost all of China’s growth since 2008 has come from “government influenced expenditure”.

Chinese government debt, including local government debt, is around 55% of GDP. There has been a parallel increase in private-sector debt. Business debt levels have reached around 125% of GDP. Traditionally considered compulsive savers, Chinese households have increased borrowing levels to 38% of GDP. Household debt has been driven by inflation. Sharply higher home prices require greater borrowings. The devaluation of purchasing power encourages debt-fuelled consumption.

In a little more than 5 years, total credit in China has expanded from around US $9–10 trillion to US$20–25 trillion, effectively replicating the entire US commercial banking system.

Unsustainable

Based on empirical measures of debt sustainability, the absolute levels and the rapid rate of increase in Chinese debt are increasingly problematic.

An increase in debt of around 30% of GDP in 5 years or less has historically provided early warning of difficulties. Several economies – Japan in the late 1980s, South Korea in the 1990s, the US and the UK in the early 2000s – experienced such rapid growth in credit, resulting in serious financial crises. China has experienced a greater than 100% of GDP expansion in debt in the last 5–7 years.

Another measure is the credit gap – the difference between increases in private sector credit growth and economic output. Studies have found that 33 countries with credit gaps experienced a subsequent rapid slowdown in growth, typically by at least 50%. In China, the credit gap since 2008 is more than 70% of GDP.

Another measure is the national debt servicing ratio (DSR), which calculates whether debt obligations can be met.  A 2012 Bank of International Settlements (BIS) research paper found that a measure above 20–25% frequently indicated heightened risk of a financial crisis. Using the BIS approach, analysts have estimated that China’s DSR may be around 30% of GDP (around 11% goes to interest payments, and the rest to repaying principal), which is dangerously high.

A further measure is credit intensity, or the amount of debt needed to create additional economic activity. China now needs to borrow around US $3–5 to generate US $1 of additional economic growth. (Some economists put it even higher, at US$6–8.) This is an increase from the US $1–2 needed for each dollar of growth 8–10 years ago. The increased credit intensity reflects the fact that more and more borrowing is being used to fund less and less productive activity.

Six reasons not to be cheerful

There are six particular areas of potential concern.

First, the borrowed funds may not have been used in activities that will generate sufficient income to service or repay the borrowings.

In China, debt has primarily financed investment, but it has been used increasingly to fund purchases of existing assets. Chinese data measures two different types of investment – gross fixed capital formation measures (investment in new physical assets), which contribute to GDP, and fixed-asset investment measures (spending on already existing assets, including land). In 2008, gross fixed capital formation and fixed interest investment were roughly equal. Today, gross fixed capital formation has fallen to about 70% of fixed-asset investment, consistent with increasing turnover of already existing assets at rising prices.

Investment in new assets is frequently focused on large-scale infrastructure and property. Stories, some apocryphal, abound about wasteful expenditure. Significant investment in politically driven superfast trains, new airports and express roads is likely to prove unproductive. Excessive investment has created significant overcapacity in many heavy industries, such as steel. Increased debt-fuelled investment in dubious projects reflects the need of ambitious government officials, especially in the provinces and at the municipal level, to meet centrally set growth targets.

Second, around half of debt is linked directly or indirectly to China’s real-estate market, where prices have risen by 60% or so in 40 major cities since 2008. Residential real-estate prices in major cities like Beijing and Shanghai are only 10% below those in New York, despite the fact that average income is China is only 10–15% of US levels. The large expansion in residential construction in recent years has resulted in a glut of properties. Official data estimates that unfinished housing stock is equivalent in value to more than 20% of GDP.

The current slowdown in the Chinese property market, with lower sales and falling prices, will have multiple effects. There will be default by property developers and construction companies, as well as homebuyers. In addition, there will be a contraction in construction and related industries, which account for 15% of GDP. The combination of reduced building activity and lower credit availability will affect growth, which in turn may drive a negative spiral in property values.

Third, major increases in borrowing by local governments are likely to prove unsustainable. This debt is structured using complex off–balance sheet vehicles to finance infrastructure, industrial parks, social housing, and other projects. Local governments have limited taxing authority and are heavily dependent on land sales to make loan payments, a source of revenue that is likely to constrained by falling property prices.

Fourth, a substantial portion of the increase in debt was via the shadow banking system, which consists of a plethora of unregulated entities. This sector accounted for as much as half of all new lending in recent years and was growing at more than 30% per annum, until recently.

The shadow banking sector poses complex problems. Its full extent is not well understood. A high proportion of loans were to the property sector, especially its more risky elements. Lending standards, quality of collateral and risk management of these loans is questionable. Central to the sector’s success were the high interest rates offered to wealthy investors. As these products were marketed by banks and are assumed by investors to be explicitly or implicitly supported by these entities, the effect of the problems is unclear.

Fifth, a large portion of the debt is secured over land and property, whose values are dependent on the continued supply of credit and strong economic growth. A high proportion of debt is short term, with around 50% of loans being for 1 year or less, requiring refinancing at the start of each year. As few Chinese borrowers have sufficient operating cash flow to repay loans, new borrowings are needed to service old ones. Around one third of new debt is used to repay or extend the maturity of existing debt. With a significant proportion of new debt needed merely to repay existing debt, the amount of borrowing must constantly increase to maintain economic growth.

Sixth, the assumption that the Chinese government has the balance sheet capacity to handle a significant financial crisis is overstated. Official Chinese government debt is a modest 55% of GDP. However, many financial institutions and corporations are state owned or sponsored, meaning, based on historical precedent, that they are effectively trading and borrowing based on implied government support. If the government had to support these entities, then China’s obligations would be materially higher.       

Unbearable

A debt-to-GDP ratio of 282% and an average debt cost of around 6% implies that the return on investment must be around 16.92%, in nominal terms, simply to service the interest on borrowing. As returns are well below this, it means that new borrowing is needed to keep paying interest on the existing debt. Given that new debt is also needed to keep the economy expanding at a reasonable level, it is difficult to see how China can manage its growing debt problem without a significant slowdown in growth, which would place additional pressure on the economy and banking system.

© Satyajit Das

Satyajit Das

Satyajit Das is a former banker and author. His latest book is A Banquet of Consequences.

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