China’s Debt Vulnerability

Western understanding of China has never greatly progressed beyond Charles de Gaulle’s statement that: “China is a big country, inhabited by many Chinese”. Despite constant analysis of developments in China in excruciating detail, economists seem to have only recently its identified debt problems. In fact, the country has had a 35-year addiction to cheap credit.

Quantum Without Solace…

Since the 2007/2008 global financial crisis (“GFC”), China has experienced strong credit growth.

The crisis and the resulting rare 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.

In late 2008, China announced a fiscal stimulus package of Renminbi 4 trillion (about $600 billion) over 2 years, a budget deficit of around 2.2% of Gross Domestic Product (“GDP”). The modest fiscal measures  were augmented by a significant expansion in credit (known as TSF (total social financing) covering a mix of loans, bonds, bills and even some equity financing) via the large policy banks, which are majority government owned and controlled.

Post GFC, new lending by Chinese banks has been consistently around 30% or more of GDP. Around 90% of this lending was directed towards 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”.

This expansion led to a rapid increase in the level of debt. Due to unreliable data and measurement problems, the exact level of debt remains unclear. Most estimates now put Chinese government (including local governments), corporate and household debt at around 200-250% of GDP, up from around 140-150% in 2008.

According to a 2013 report from China’s National Audit Office (“NAO”), Chinese government debt, including local government debt is around 55% of GDP (around US$5 trillion), an increase of around 60% from 2010.

The NAO argues that this figure includes around US$ 1.6 trillion of contingencies (debts of government owned financing vehicles) of which the government in the worst case would only have to cover a small portion (say 20%). This would reduce the actual public debt to around 39% of GDP.

Official Chinese government debt figure may not be complete, as it may exclude debts from local governments and central departments outside the Finance Ministry. It may also exclude debt of large state owned enterprises, state-owned policy banks and special purpose asset-management companies that hold nonperforming loans purchased from state-owned commercial banks, which all trade on the basis of an explicit or implicit government support. For example, China’s Railways has debt of US$270 billion, which may not include, despite the fact it is run by a central government ministry.

If these items are included, then China’s government debt including contingent liabilities would be higher, perhaps 90% of GDP.

There has been a parallel increase in private sector debt. Business and household debt levels have reached around 150-170% of GDP, a large increase from around 100-115% in 2008. Corporate debt has increased sharply, approaching 150% of GDP. Historically, Chinese governments have supported many large, strategically important or politically well-connected private corporations meaning that some corporate borrowing may end up as public debts.

Traditionally considered compulsive savers, Chinese household have increased borrowing levels from around 20-30% to 40-50% 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.

Beijing City Limits…

There is now belated concern about the sustainability of Chinese debt. Analysts’ behaviour recalls George Eliot in Middlemarch: “We are all humiliated by the sudden discovery of a fact which has existed very comfortably and perhaps been staring at us in private while we have been making up our world entirely without it.

Whilst high, China’s debt level is lower than developed economies, allowing government officials to claim that it is at a “safe level”. But developed economies may not be an appropriate benchmark as generally emerging nations, like China, have lower debt capacity reflecting shallower and less developed financial markets which are in the early stages of “financial deepening”.

If all debt is included then the China overall debt is high, especially when benchmarked against comparable emerging markets. Many Asian emerging markets had lower debt and higher per capita GDP prior to the Asian monetary crisis of 1997/ 1998. Interestingly, China has similar debt levels but lower per capita income as Japan prior to the collapse of its bubble economy in the late 1980s.

Private sector debt levels are lower than that in developed markets such as the US or UK (200% of GDP) but is much higher than the 50-80% levels common in emerging markets. Household debt remain well below personal debt levels in the US or Europe (above 100% of GDP) but are increasing.

Corporate debt levels are above developed countries (averaging around 90% of GDP) and well above those of firms in other emerging markets (less than 100% in Brazil, around 80% in India and 60% in Russia).

The high debt levels are exacerbated by an inverted debt structure (described by Michael Pettis in his book The Volatility Machine). In emerging nations, when the economy slows debt levels, both direct and contingent, increase rapidly.

In addition to the absolute levels, the rapid rate of increase in debt is also concerning. There are a number of empirical measures.

An increase in debt of around 30% of GDP in 5 or less years is regarded as problematic. Several economies – Japan in the late 1980s, South Korea in the 1990s, the US and UK in the early 200s – experienced such rapid growth in credit resulting in serious financial crises. China has experienced a similar expansion in debt. Such consistent above trend increases in borrowing levels have historically provided early warning of problems.

Another measure is the credit gap – the difference between increases in private sector credit growth and economic output. Research 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 over 70% of GDP.

Chinese credit intensity (the amount of debt needed to create additional economic activity) has increased. China now need around US$3-5 to generate US$1 of additional economic growth, although some economists put it even higher at US$6-8. This is an increase from the US$1-2 need for each dollar of growth 8-10 years ago. The increased credit intensity reflects the use of funds.

Debt can be used to finance investment, consumption or on assets that already exist. Consumption or investment contributes to economic activity. Purchase of existing assets does not add directly to economic activity.

In China, debt has primarily financed investment but 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 contributes 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 frequently rising prices.

Investment in new assets is heavily focused on frequently large scale infrastructure and property. The major concern is that many of the projects will not generate sufficient income to service or repay the borrowing used to finance the investment.

Stories, some apocryphal, abound about wasteful expenditure. Significant investment in politically driven super-fast trains, new airports and express roads is likely to prove unproductive. Excessive investment has created significant over capacity in many heavy industries, such as steel.

China has also benefitted from a large expansion in residential construction in recent years, resulting in a glut of properties. Official data estimates that unfinished housing stock is equivalent in value to more than 20% of GDP. The most infamous is the “ghost city” of the Kangbashi district of Ordos in Inner Mongolia, which at one stage had apartments to shelter a million persons, about four times its current population.

But other less obvious but equally troubling examples are available. The city of Tiajin, about a half hour by high-speed train southeast of Beijing, has invested more than US$160 billion in an effort to create a financial centre. The amount spent is almost three times the amount spent on China’s Three Gorges Dam, one of China’s costliest projects. Changde, a city of 6 million in Hunan province in Southern China, has raised more than US$130 million in debt to finance amongst other things an international marathon course, following the 2008 Beijing Olympics.

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. As Yuan Zhou, then mayor of Guiyang, capital of the south-western province of Guizhou, stated in a radio interview in 2011: “We need to struggle for GDP. Only with higher GDP will people’s lives be improved.”

The increased level of debt and the often uneconomic projects financed has led to increasing concern as to whether the debt can be serviced.

A 2012 Bank of International Settlements (“BIS”) research paper on national debt servicing ratios (“DSR”) found that a measure above 20-25% frequently indicated heightened risk of a financial crisis. Using the BIS, analysts have estimated that China’s DSR may be around 30% of GDP (around 11% goes to interest payment and the rest to repaying principal), which is dangerously high.

The debt problems are compounded by other factors. A large portion of the debt is secured over land and property, whose values are dependent of the continued supply of credit and strong economic growth.

A high proportion of debt may be short term, with around 50% of loans being for 1 year, 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 to merely repay existing debt the amount of borrowing needs to constantly increase to maintain economic growth. The process is not seamless and the requirement for regular refinancing exacerbates the risk of financial problems.

The concern is that debt fuelled investment has created economic growth but in the medium to long term will result in rising bad debts and financial problems.

Economist Hyman Minsky identified three phases of finance during periods of prosperity, with financial structures become progressively more risky. Hedge financing is where income flows can meet principal and interest on debt used as finance. Speculative financing is where income flows cover interest payments but not principal, requiring debt to be continually refinanced. Ponzi finance is where income flows cover neither principal nor interest repayments, with the borrower relying on increasing asset values to service debt.

China observers now worry about whether the high absolute levels of debt, rapid increases in borrowing, increasing credit intensity, servicing problems and the quality or value of underlying collateral are likely to result in a financial and economic crisis – a Minsky Moment.

© 2014 Satyajit Das

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money