Over the past seven years, China has experienced one of the largest and most rapid debt build-ups of modern economic history—larger and more rapid than the credit expansion that preceded Japan’s crisis in the early 1990s and the one that led to the Great Recession of 2008. As the recent turmoil in the markets reflects, more and more investors and policy-makers are beginning to focus on what may be the beginning of a Chinese debt crisis, marked by a serious slowdown in economic growth and falling demand for commodities and other goods. To gain a better understanding of China’s debt problem, we have invited a number of China economic and financial experts to offer their analysis of how the huge build-up of China debt will affect China’s economic growth and its financial stability in the coming months and what options China has for managing its build-up to avoid a financial crisis or a major or prolonged economic downturn. In an accompanying report (see Essential Research), we present a detailed map of China’s debt build-up and the huge overcapacity it has created.
Yan Liang, Associate Professor, Department of Economics, Willamette University.
Diana Choyleva, Chief Economist, Head of Research, Lombard Street Research.
Christopher Balding, Associate Professor of Economics, Peking University, HSBC School of Business.
Henny Sender, Chief Correspondent for International Finance, The Financial Times.
Richard Vague, Managing Partner, Gabriel Investments.
China’s Coming Debt Crisis?
Yan Liang, Associate Professor, Department of Economics, Willamette University.
China has relied on credit driven, investment led growth in the past decades and its double-digit growth record has been nothing but impressive. However, this growth model has encountered mounting difficulties and China today is wresting with a vexing problem with debt. A high level of private and and semi-private debt, coupled with the declining quality of that debt, has rendered the private sector vulnerable; and yet, aggressive deleveraging could further decelerate the economy, producing a vicious “credit spiral”.
The debt to GDP ratio has reached 217% of GDP (or 281% of GDP, if financial sector debt is included) in mid-2014, up from 134% in 2007. This level is rather unprecedented in China’s history, despite its long tradition of credit driven growth. Since China’s market reform in the 1980s, State Owned Commercial Banks, the backbone of China’s financial system, have lent generously to State Owned Enterprises (SOEs) to finance the latter’s fixed asset investment. Credit extension helped mobilize resources and facilitate China’s industrialization and urbanization, whereby engendering a Keynesian-Schumpeterian credit-investment-growth cycle. But this model has gradually run out of steam, as it causes debt accumulation, puts a heavy toll on natural resources and generates rising supply glut in recent years. Chinese policy makers have realized the limitation of the growth model and called for rebalancing, shifting demand from credit driven investment and export to consumption. However, the rebalancing plan did not effectively bring about a reduction of debt; rather, leverage heightens and debt continues to accumulate.
Two main factors account for the elevated indebtedness. The first is the continuous credit expansion; in particular, after the 2008 global financial crisis, the government launched a $586 billion stimulus plan funded mainly through credit and in the meantime, ordered banks to lend aggressively. Banks listened; $15 trillion, equivalent of the entire U.S. commercial banking sector, were lent out in just five years. Later in 2010, despite authorities’ order of credit tightening; many of the projects that have been launched called for continuous financing. The second factor is the deceleration of the economy. GDP growth rate declined to a mere 6.9% as of the third quarter of 2015; but the total social financing (TSF), a broad measure of total credit flows, rose by 13%. The growth rate of TSF has indeed moderated compared to last year, but slower GDP growth rate elevates the debt to GDP ratio.
Rising debt to GDP ratio is of concern, but what is more problematic is the worsening quality of debt. This is manifested in three aspects: first, shadow bank (or, non-bank financial institutions and bank off-balance sheet entities) lending has become a significant source of credit since 2008. It is estimated that $6.5 trillion, or 30% of total loans outstanding were lent by shadow banks. Between 2007 and mid-2014, bank lending grew at an annual rate of 18% while shadow lending doubled that. These shadow institutions, comprised mainly by wealth management products (WMPs), trust loans and entrusted loans, are lightly regulated and thinly capitalized and cushioned than formal commercial banks. For example, according to the IMF data, the top 10 trust companies have as much as 40 times the asset under management to equity ratio. Worse still, despite their low capacity to withstand risks, shadow banks tend to make riskier lending. For example, WMPs, which are essentially informal securitization of loans and other credit products issued by banks and trust companies, typically have a short-term maturity. In 2007, less than 10% bank WMPs were less than 90 days and more than 50% were a year and above; by end 2010, about 40% were less than 90 days and less than 20% were a year or over. But funds raised through WMPs were often invested in long-term projects such as property development. Moreover, shadow banks tend to lend to borrowers that are considered too risky, unprofitable or unsupported by the government and hence rejected by formal banks. These include local government financing vehicles (LGFVs), real estate developers and industries with excess capacities. These lending practices make shadow lending much riskier than formal bank lending, thus weakening the quality of debt.
Second, looking at the sectoral distribution of debt, the non-financial corporates have the highest share and growth of debt. They accounted for 125% of the total debt as of mid 2014, up from 72% in 2007. The increased leverage in the corporate sector is coupled with a declining capacity to pay. According to the IMF dada, the share of loss making listed nonfinancial companies increased from 5.5% in 2007 to 17.3% in the first quarter of 2013; median return to assets dropped from 6.5% to a mere 2.4% during the same time period. Furthermore, within the corporate sector, debt concentrates in industries that are plagued with excess capacity. McKinsey & Co. points out that half of the debt resides in the real estate and related sectors, and yet the real estate market is highly saturated and prices have been adjusting downward in many second- and third-tier cities. The IMF data shows that cash flows from the real estate sector recorded at -103 billion yuan while cash flows from financing were 116 billion yuan as of mid 2014. This suggests that the real estate sector was not able to pay off debt from normal income streams but relied on continuous refinancing. Another sector that harbors large amounts of debt is the local governments. At 55% of GDP, China’s government debt was not high by international standard; however, local governments accounted for 51% of the total government debt. Because local governments typically have a large revenue gap (they are responsible for much social spending but lack access to lucrative tax sources) and are not allowed to issue bonds (with the exception of a few local governments in recent years), they set up LGFVs to take out loans from banks or shadow banks. McKinsey & Co. estimated that these LGFVs took out $1.7 trillion loans as of mid 2014. Given the tepid economic growth and hence fiscal revenue growth, as well as the downward adjustment of land value (which is often used as collateral), it is dubious that local governments are in a good position to repay the debt.
Finally, although credit has been expanding rapidly, its contribution to new investment is diminishing. If credit expansion could promote sufficient GDP growth, then it would mean that the capacity to pay off debt rises in tandem with debt. However, this is not happening in China now. Between 2004 and 2007 it took 1.01 yuan of private credit to generate 1 yuan of GDP, but the ratio increased to 1.8 during 2010-13. This is partly due to the fact that capital efficiency has been falling, as the incremental capital to GDP ratio increased from 2.5 to close to 5.5 from 2007 to 2012. As mentioned above, a large share of shadow lending went to industries with excess capacity or LGFV funded infrastructure, many of which are economically unviable. Moreover, credit is increasingly used for purposes other than financing new investment. One of the worst cases is where credit is used to pay for debt services. Due to the fact that shadow lending accounted for an increasing share of credit and it typically charges higher interest rates, it is not surprising that interest expenses grew at an annual rate of 27.8% in China during 2007-12, highest among all the large emerging markets. According to the BIS data, private non-financial corporations’ debt service ratio increased from 13% in 2008 to 20% as of first quarter of 2015. As a result of falling profitability and rising debt services, Chinese firms resorted to borrowing to cover their debt obligations. Beijing based Hua Chuang Securities Co. estimated that 7.6 trillion yuan ($1.2 trillion) credit, or 45% of the new TSF, was used to make interest payments. Using new loan to make interest payments on old debt indeed resembles a Ponzi finance scheme, as some observers aptly called it.
All told, then, the Chinese economy, especially at the corporate and local government level, is inundated with debt, and the quality of debt is slipping. Some observers caution that the 83 percentage points increase in debt (in percentage of GDP) during 2007-14 put China in the league of crisis-wrecked countries like Ireland, Portugal and Greece. However, China’s situation is unique and different from those countries. First, China’s debt is predominantly domestic owned. It is true that Chinese corporations have been tapping cheap global credit; in 2003, non bank corporations took out $366.4 billion new foreign loans. Although the amount seemed large, it was only about a quarter of the $1.45 trillion in new domestic loans lent by Chinese banks. Furthermore, China’s external debt, recorded at $960 billion in 2014, was only 9 percent of GDP and 35 percent of export and primary income revenues. This suggests that China has the means to honor its external debt. In addition, China has accumulated close to $4 trillion foreign exchange reserves. All these would help stave off disorderly capital outflows that could trigger banking and currency crises. Second, the financial system is still dominated by state controlled commercial banks; and although banks’ asset quality has declined in the recent years, the amount of nonperforming loan (NPL) is still low and capital buffers abundant. According to the IMF data, the NPL as a percent of gross loans stood at 1.23 percent for large state-owned banks, 1.12 for joint stock banks, 1.11 for city banks and 1.87 for rural banks. This means even if NPLs of shadow banks partly migrate to banks’ balance sheet given their tight connections and contagion risks, the low base would provide some room for the increase. Further, capital as a percentage of risk weighted assets weights in at 12.62, 10.05, and 10.62 percent for state-owned banks, joint-stock banks and other banks, respectively. These are two to three times the level of capital requirements by Basel III. It seems that banks have the capacity to weather through financial difficulties should shadow banks go under.
Finally, the Chinese central government has the policy will and financial resources to write off bad debt and recapitalize banks. According to a Fung Global Institute’s research report, China’s national balance sheet shows that the public sector had net assets of 87 trillion yuan. Not to mention that the central government is essentially a monopoly of the sovereign currency. This means that the central government could restructure local government debt as sovereign debt, write off bad loans on banks’ books and recapitalize them, and even support the real estate market through land purchases, etc. All these drive home the conclusion that a full-blown debt crisis is unlikely to erupt in China in the near future. However, the heavy indebtedness may scar the corporate sector and put constraints on local governments over an extended period, as they struggle to meet debt obligations and trim investment and discretionary spending.
The challenges for policy makers are daunting because of the conflicting goals of deleveraging and stimulating growth. There are three major policy dilemmas. First, monetary easing could help reduce debt service costs. Indeed, the People’s Bank of China has waged six rounds of interest cuts since November 2014, as well as lowered the reserve requirement ratio for four times in 2015. Yet, monetary easing would risk inducing more credit and perpetuate the credit easing - debt accumulation cycle. Second, cracking down the shadow banks helps stall credit expansion but risks harming many small and medium sized enterprises that rely on shadow lending. Policy makers must be vigilant and take measured steps in trying to achieve the dual goals. Third, rebalancing the economy could have potential long-term benefits but it could worsen the debt burden in the short run, if the economy continues to slow down.
Luckily, recent months have seen several sound policy initiatives. In dealing with local government debt, the Ministry of Finance has allocated a quota of 3.2 trillion yuan for bond issues to provincial governments to redeem maturing LGFV debts. This not only helps make local government debt more transparent but provide some relief. This kind of specifically targeted debt restructuring and management program works better than the cross-the-board monetary easing. Further, policy makers start lifting the ceiling on RMB deposits, launched deposit insurance scheme and loosened loan-to-deposit ratio requirement for banks. All these would help curb shadow banking growth as they lessen regulatory arbitrage between formal banks and non-bank financial institutions. Finally, rebalancing continues, as policy makers started to alleviate excess capacity in industries such as steel, cement, aluminum and glass-making, as well as cool down the property market. Although letting go the failed enterprises and rid excess capacity is overridingly critical, it would only proceed in a very slow and limited pace given all the economic and political obstacles. The key to strike the balance between rebalancing the economy and maintaining healthy growth is to promote consumption and to develop the service sector. Policy makers must act right, and quickly, before it is too late.
Defusing China’s Debt Bomb
Diana Choyleva, Chief Economist, Head of Research, Lombard Street Research.
China’s economy is losing steam fast under the burden of crippling local government and corporate debt. Its debt restructuring plan is now taking shape but, so far, it amounts to little more than creative financial engineering. By refusing to countenance meaningful defaults, Beijing is yet again sweeping its problems under the carpet. Debt has increased at an alarming pace over the past few years but has not yet reached excessive levels, so policymakers can still play for time. However, they cannot delay for another decade. Encouragingly, the new leadership in Beijing has made important headway over the past three years opening up and liberalising its financial system.
China's export and investment led growth model is broken. The global financial crisis (GFC) has put an end to it. The resultant prolonged period of weak global growth, and now three to four years of an overvalued yuan, mean that Beijing can no longer throw money at unproductive investments without domestic debt building up fast. By our estimates, total non-financial debt, including the shadow banking sector and the gray economy, had shot up to 260% of GDP by 2015. The economy has suffered a sharp structural slowdown, with real GDP growth halving to 6% so far this decade. Last year, and during the first three quarters of this year, quarterly annualised growth averaged just under 4%.
Where is the bad debt?
Official data shows that bad loans in the Chinese banking system are negligible. Indeed, despite internationally audited bank accounts, investors are right to mistrust the official figures for non-performing loans (NPLs). Even though NPL ratios and loan loss provisions have climbed recently, the numbers still make no sense given the leap in the debt-to-GDP ratio and stagnant corporate profits and deposits. Hardly anyone believes these official numbers, even within China. Policymakers presumably do have a better idea of the real size of the problem, at least when it comes to local government debt.
The National Audit Office (NAO) carried out two comprehensive audits of local government debt in 2013 and 2014. In the first, the authorities admitted that total debt was much higher than previously thought. The 2014 audit went further in acknowledging that 20% of recent new loans were going to repay older debt. Actually, if we consider that overall corporate loans as a share of GDP rose by 22 percentage points in the past three years while corporate deposits as a share of GDP fell marginally, it is highly likely that most of the new bank loans (a chunk of which is hidden government debt) were used to repay existing debt.
A window of opportunity for clean-up
The Chinese authorities have a narrow opportunity to clean up this mess and achieve a sustainable rebalancing of the economy. The era of miracle growth is over, but after a messy couple of years of adjustment, if successful, China should be able to grow at 5% a year. However, if they simply use creative financial engineering to hide the bad loans and persist in flooding the economy with more debt, China is likely to see the end of its catch-up growth phase much sooner than Japan did. Allowing defaults over the next several years will be the acid test of Beijing’s intentions.
Is China bust?
Despite the alarming leap in non-financial debt, our assessment suggests that Beijing will be able to finance the clean-up of past excesses one last time. Let’s assume that all new net non-financial corporate bank credit in the past three years was actually used to roll over bad debt. Under the further assumption that half of loans to the gray economy, household credit and corporate bonds are bad and the recovery rate is zero, then China’s non-performing loans could be as high as 60% of GDP. This extreme scenario is worse than China's debt problems of the early to mid-1990s, much worse than the US savings and loan crisis and worse or equal to the estimated cost of the GFC.
We estimate gross government debt totalled 55% of GDP in 2015. If the government takes all the bad debt explicitly onto its balance sheet in a one-off clean-up, gross government debt will more than double to 115% of GDP. This is a huge increase by any standard, but international experience suggests it is not unsustainable. Japan has managed to live with a much higher gross debt-to-GDP ratio for years, even though its nominal GDP growth has been much weaker than China's is at the moment. This comparison is apt in that both countries’ non-financial debt is predominantly held by domestic investors.
The local government bailout plan
Policymakers have, so far, focused their efforts primarily on restructuring local government debt. Sub-national governments found a way around the ban on borrowing directly from banks by setting up intermediaries to do the job. At Beijing’s behest, these local government financing vehicles (LGFVs) went on a borrowing spree after the 2008 crisis to prop up growth. The results were predictable. Poorly conceived and executed projects flopped, forcing Beijing to spring into action to clean up the mess.
The process started in 2011 when the China Development Bank (CDB), the country's de facto second Ministry of Finance (MoF), began working with local governments to buy their loans from commercial banks. The CDB, in turn, funds itself by selling long-term bonds to the banks. This arrangement has been a double-edged sword for the lenders. Despite longer maturities, yields on CDB bonds are lower than the interest rates charged to LGFVs, compressing bank margins. But as the swap was at face value and CDB bonds carry a zero risk weighting, banks' capital adequacy ratios ended up in better shape.
In 2014 the PBoC rolled out a new monetary policy tool, called pledged supplementary lending (PSL), which offers three-year loans to selected lenders, mainly the CDB, at below-market rates to support specific sectors.
The first indication that Beijing was serious about another bank clean-up was the "stealth" bank recapitalisation that the MoF carried out in 2012 by acquiring, at face value, the majority of the bonds of two of China’s four main asset management companies in preparation for their IPOs. (Cinda and Huarong have both since listed their shares.) The four AMCs, which were created to warehouse distressed debt, are now allowed to expand into brokerage, fund management, insurance and leasing. The aim of turning these brokerages into viable commercial firms, at least on paper, stems from the realisation that if these AMCs are to take on even more bad debts in the next few years, they cannot yet again be primarily funded by the state banks.
The birth of a municipal bond market
The most important part of the clean-up plan is the creation of a municipal bond market. The pilot program that began in 2011 was extended to 10 local governments in total which, in addition, were also allowed to service these bonds themselves on the condition of more rigorous financial disclosure. By the end of the year, Beijing had approved changes to the budget law allowing local governments to issue bonds directly and separated local government from the opaque LGFV debt with some LGFV loans reclassified as government debt.
Last March, China’s 31 provinces and five provincial level cities received a quota of Rmb1 trillion to issue bonds to refinance principal payments falling due this year. In mid-June, Beijing doubled the amount to Rmb2 trillion. The amount eventually reached Rmb 3.2 trillion by the end of 2015. The aim is to substitute expensive, short-dated LGFV debt with low-cost, long-dated municipal paper. According to the MoF, the program is meant to refinance all of the local government debt without increasing government liabilities or the fiscal deficit. Since banks, the main potential buyers, were allowed to pledge the bonds as collateral at the central bank, sales have been smooth. The MoF has planned to complete the program within three years, hoping to lower the interest payments on the remaining local government debt. 2016 should see another substantial round of new debt swaps.
While local government debt restructuring is under way, Beijing has so far been loath to allow meaningful defaults. Some argue that sanctioning company, wealth management products, or LGFV defaults would sow panic among retail investors. Yet ultimately, relaxing top-down, direct economic control is a precondition for genuine financial market reform. If China is to have a proper bond market, LGFVs that have lost their government guarantee will have to face much higher financing costs. Some will go bust and it is important that the authorities permit them to go under if risk is to be priced properly. Ratings on local governments, currently all AAA, should vary in order to reflect their different financial positions. Interest rates should not be mandated and banks should not have their hands twisted into accepting government paper at unattractive yields.
Financial market liberalisation is good news
The lesson from Japan in the 1970s and 1980s is that change drives change and liberalisation becomes unavoidable. The good news is that China’s new leadership has resolved to carry out financial reform, shifting the status quo in favour of households at the cost of the banks by liberalising the setting of interest rates and freeing up its capital flows. Banks need a complete overhaul if the economy’s transition to consumer-powered growth is to succeed and if bad debts are to stop piling up.
Headway on financial reform has been remarkable over the course of this year, in part to meet the IMF’s conditions for including the Yuan in the Special Drawing Right (SDR), the Fund’s basket of reserve currencies – a decision duly announced on November 30. In addition to scrapping remaining restrictions on how much interest banks may pay depositors, China has abandoned the Yuan’s long-standing dollar peg. The PBoC now manages the Yuan’s value in relation to a basket of currencies, an important step towards making the Yuan more responsive to market forces. It has allowed more freedom in the movement of capital, in particular adding the ground-breaking Shanghai-Hong Kong connect scheme, allowing unrestricted two-way movement between the Shanghai and Hong Kong equity markets.
Some worry that financial liberalization and the internationalization of the RMB will make the management of the debt overhang riskier or more difficult. Ideally, it would have been easier if Beijing could have started opening up with a less fragile banking sector. At the same time, shielding it over the years has created a false sense of security and allowed the build-up of the current debt problem. The authorities should act sooner rather than later and will have to deal with the unenviable task of keeping many balls in the air. It is an enormous challenge, but Beijing has no option to delay action any more.
Banks, burdened with bad corporate debt and seeing their profit margins squeezed by the local government debt swap will need to raise new capital to keep their capital adequacy ratios from falling. With Basel III rules coming into effect and deposit rates now liberalised, it will be difficult for banks to replenish capital through profit growth. Beijing is keen to foster mortgage securitisation as a way of providing income for banks and freeing up bank capital. China’s mortgage market is underdeveloped, so there is scope for genuine growth. Still, recapitalisation is needed and Beijing has come up with two main methods – selling subordinated debt and preference shares. Another key banking reform is the injection of competition by allowing the establishment of private banks.
Successfully managing all of these difficult reforms is a tall order and Beijing’s heavy-handed intervention to prop up the stock market last summer was a mistake that dented confidence in Chinese policymakers. But the challenges they face are so huge that blunders along the way are unavoidable. By moving away from the Yuan-Dollar peg, opening its capital account and allowing market forces in its domestic financial market, China is addressing the most important causes of the financial imbalances dogging the world. The hope is that Beijing will ultimately manage these critical reforms more or less successfully.
Perpetuating the China Debt Bubble
Christopher Balding, Associate Professor of Economics, Peking University, HSBC School of Business
Like many governments in the wake of the 2008 global financial crisis, China embarked on an ambitious fiscal stimulus program to aid growth. However, China extended the program beyond what others contemplated. Rather than simply providing direct revenue assistance to local governments or boost central government spending, it encouraged banks to provide leverage for publically approved projects. This both increased the impact of the fiscal stimulus by adding bank leverage to direct government spending but also shifted policy by explicitly encouraging debt.
The ensuing investment and infrastructure construction boom was truly one of the most frenzied periods in human history. It has been estimated that China consumed more concrete in a couple of years than the United States did in the entire 20th century. Entire cities were constructed, thousands of mile of high speed rail were laid, and industries built from scratch. It was the Golden Age of Capital in China.
This explosive period of investment and borrowing, however, also has an important downside. Given the centralized mandate to boost investment, and the lending necessary to facilitate it, enormous amounts of wasteful investment ensued. Today most industries operate at 50% of capacity. Most airports in China lose money with many, after enormous investment, receiving only a couple flights a day. To compound this problem, since 2009, debt levels in China have exploded growing far in excess of GDP or cash flows required to repay the loans. The Bank for International Settlements has warned that historically, the recent period of credit expansion in China was one of the largest in history significantly raising the risks of future dislocations.
Worryingly, China seems unable to even recognize, much less face up to and tackle, this credit overhang. Bankers seem oddly oblivious or unaware of the enormity of the increase in credit growth China has experienced. Investors seem uniquely sanguine about default or non-performing loan (NPL) risks in China, emphasizing that the government will solve the problems or that this distressed private debt is guaranteed. Virtually all onshore bond defaults in China have eventually been bailed out with investors losing no money, despite an officially expressed desire to increase market risk and pricing. Though defaults and NPLs are rising rapidly, firms, households, and governments seem willing to continue their debt binge increasing the risks when deleveraging ultimately comes.
Even most of the Chinese government seems strangely unaware or unconcerned about the debt buildup. While there have been some public statements about slowing the growth of debt with a recent policy announcement using the word “deleveraging”, all evidence indicates that local governments continue to run sizeable deficits and firms continue to receive bail outs to maintain stability. Consequently, debt continues to grow at approximately twice the rate of GDP with approximately 50% of new debt simply used to repay old debts. China is caught in a debt trap with new credit being used to roll over the old debt and the credit intensity of growth essentially unchanged. While press releases and policy planning may note the problem, there seems to be little real emphasis on slowing credit growth and even less on concretely addressing the rapid expansion or its historical legacy.
Given this background, there are a number of important points about what we can expect from the Chinese economy and what should be done. First, as Chinese growth will come under increasing pressure it will be important to distinguish economic health reality and propaganda. China has declared that it will average 6.5% growth through 2020 and, officially, there should be little doubt, barring obvious and visual catastrophe to the economy, this figure will be achieved. However, rather than simply accept the headline number, it will be important to measure China’s economic health by focusing not on headline GDP figures but on underlying data like output and revenue. In China, there is typically a wide and growing divergence between these numbers.
Second, we need to distinguish between the types of economic growth. Historically, and especially in the past decade, China has relied heavily on fixed asset investment propelled primarily by rapid credit expansion to fuel growth. Though China touts its ongoing shift to a consumer and service-led economy, it still overwhelmingly relies on fixed asset investment and credit growth to drive GDP growth. In an economy where rolling over a non-performing loan counts as GDP growth attributed to financial services, what drives GDP growth will be very important.
Moving beneath the headline number of retail sales growth for instance, we see a very different picture of the so called rebalancing. Mobile phone output flat, with even Apple CEO Tim Cook noting that while Apple enjoyed a good year in China, smart phone market growth nationwide has been stagnant. Passenger travel, by number of trips, is up minimally with hotel revenue flat for the year. Expanding to a range of consumer goods like garments, accessories, and consumer durables, output and consumption is either flat or falling. The rebalancing of the Chinese economy may be happening but only because services and consumption are not falling as fast as manufacturing and industry. The current fiscal and monetary stimulus coupled with loosening credit, targeted at major SOEs and infrastructure, imply a broad continuation of historical growth policies and continued rapid credit growth rather than any kind of shift toward consumption-led growth.
Third, the rapid historical expansion of credit and investment imply future slowdown of economic growth. Given the enormous surplus capacity in areas like basic infrastructure to factories and real estate, just to name a few, it will take many years to work through this back log of surplus. For instance, Chinese media estimates that the average household currently owns approximately 1.2 units of housing with an estimated 50 million more units under construction. As population growth stagnates, migration slows down, and housing stock is lost at normal rates, the stock of surplus housing will take many years to work through. This implies that housing investment will be lower in the future, certainly lower than has been the historical norm. If China attempts to boost economic growth by maintaining high investment levels, , this means that growth will be weaker at some later point. In other words, by creating surplus capacity, Chinese authorities have merely time-shifted investment forward, stealing from future growth.
Fourth, the surplus capacity and growth pressures are going place enormous debt pressures on China. As noted earlier, one firm estimated that 50% of all debt raised is being used to pay off old debt with similar expectations for the next few years. With falling prices and output, low demand, and surplus capacity, many Chinese firms are caught in a classic debt deflation spiral. Debts for many continue to rise by more than 10% annually while revenue is flat or falling. Profitability is falling across a variety of sectors from industrial to financial firms placing significant pressure on investors and banks which are now facing a rising tide of NPLs. Given China’s industrial structure and macroeconomic targets imposed from Beijing, we should expect the current conditions to persist: firms will try to stay alive even if by using unhealthy measures to do so and banks seek to avoid loss recognition. The primary objective is to live to fight another day.
Fifth, and most important, despite problems with debt, the probability of a typical debt crisis must be considered low. Conversations of a “China Lehman moment” fail to grasp the internal structure and objectives of Chinese policy makers. China will only have a Lehman moment, or financial collapse of any real importance, if all other possibilities at prevention and obfuscation have been tried and failed. While bond defaults and non-performing loans have risen in China, the practice has been for China’s banks and authorities to bail out onshore investors rather than to allow businesses to collapse or investors to lose money. Beijing’s obsession with stability extends to investors, governments, and banks. The political legitimacy of the government depends on sustained rapid economic growth and management that it can cite as justification to maintain its grip on power.
Even at current significantly elevated rates of debt and other economic stress levels, it seems unlikely that an economic or financial crisis is imminent in China. As the Bank for International Settlements has noted, the recent Chinese credit expansion as one of the largest in recent modern history relative to trend, places it in an extremely high risk category for financial crisis. Beijing will ensure as long as possible that no strategically or systemically important firm or local government will collapse. The reason is simple: Beijing knows that if China ever endures a financial or economic crisis, that will mean the end of Communist rule in China. An economic crisis will only occur in China if all other options and attempts to prevent it have utterly failed.
Consequently, financial market policy in bank, bond, and equity market regulation will work to maintain elevated capital price levels rather than cultivating well functioning markets that allow firms to disappear. Firms and investors will continue to receive bailouts to maintain stability until it is simply no longer possible. This implies an inherent policy conservatism that allows Beijing to maintain an iron grip on the control of capital flows and how investors and firms behave. While Beijing publicly seeks to liberalize the currency, expect incredibly slow movement here as they cannot move to free the RMB without provoking a crisis. The recent crackdown on investors, hedge funds, and bankers should not be seen as merely a one-off event, but a likely sustained policy to impose government will on finances to maintain stability the economy. This does not mean a financial crisis cannot happen, rather that it should be considered the last ultimate and lowest probability outcome.
The Chinese economy is growing much slower than official data indicates and the stresses associated with a historical credit expansion is rapidly beginning to show. This will undoubtedly raise the risks for firms, the government, and the country going forward across a variety of indicators. However, it is more likely that these problems will result in many years of slower and lower quality growth rather than collapse. While a China willing to face its debt problem and tackle hard issues of economic and financial reform would be preferable, expect a lot more muddle than action.
The Good and the Bad of China's Transformation and Debt Management
Henny Sender, Chief Correspondent for International Finance, The Financial Times.
With the recent market turbulence, it is especially easy these days to be gloomy about Chinese prospects. As forecasters polish their predictions for the year of the monkey, most identify China risk as their foremost concern. They anticipate either an economic disaster or a financial crisis—or both. Almost every factor points to gloom. Add them up and you have a situation where they all reinforce each other, and what follows potentially is a vicious downward spiral.
Transitions are always fraught and the transformation of the Chinese economy, from a manufacturing powerhouse, churning out goods at ever declining prices and selling them to the rest of the world to an economy built on demand for services from ever more affluent consumers, seems especially fraught. The stakes are high for the rest of the world, given that China has accounted for anywhere from one third to one half of incremental demand in the last decade.
China, which seemed for so long to have been immune to the laws of cycles, is finally succumbing, the pessimists say. Slowing growth, a declining trade surplus, shrinking reserves, capital outflows, a dropping renminbi, stressed corporates, and weaker bank balance sheets all appear to support the case of the bears.
So does the fact that there have been virtually no examples of countries in which the build-up of debt has been as rapid as in the case of China in which there hasn’t been a major problem. And the build-up of the debt has been without precedent. In 2008, mainland non-government debt, (excluding that of the financial sector), was 90 percent of GDP, according to data from JP Morgan. By the end of 2014, that debt figure had swelled to 140.6 per cent of GDP. Alas! It is still growing. By the end of 2015, it was expected to amount to over 150 percent. The real burden of that debt is also rising because China, unlike many of its peers, can’t count on inflation to reduce the load. Producer price deflation is now 5.2 percent, having risen throughout this past year.
At the same time, China’s growth rate has also been coming down. Third quarter GDP came in at 6.9 per cent, with the last quarter of 2015 expected to see growth of a less impressive 6.7 percent, and 2016 less than that. That slowing GDP points to the declining efficacy of investment, as it takes ever more renminbi (or dollars) to produce the same increment of growth. Moreover, arguably, the quality of that growth looks to become ever more suspect. No matter how many coal mines are closed, how many steel mills shut, and how many cement plants idled, there is still excess production, much of it poor quality.
China’s trade surplus, so massive that it enabled the country to accumulate $4 trillion in foreign exchange reserves, has begun to slow as well, narrowing every month since the summer. And from that peak figure of $4 trillion in foreign exchange reserves, reserves now have come down to just over $3.3 trillion. In 2015 alone, China will have lost over $600bn—or far more than India, with around $350bn, has in total. Suddenly a country that had the delightful problem of having too much money in its coffers looks vulnerable to having too little.
The renminbi, which until recently rose in lockstep with the dollar, is today decoupling from the greenback as the latter continues to rise. That is partly by PBOC design and partly because many investors and citizens of China have lost confidence in the redback. In Hong Kong, renminbi deposits are down over 10 percent from the beginning of 2015, as prudent citizens turn back to the dollar. Inept communication from the central bank as it tries to get the market to focus on the value of its currency against a trade weighted basket rather than against a rising dollar has only added to the market’s doubts on the renminbi.
Meanwhile, outsize debts are only a small part of the challenges facing Corporate China. Industrial profits are dropping today, which means that isolated cases of defaults threaten to become more numerous tomorrow. And while the banks have recently increased the problem loans on their balance sheet to about 1.5 percent of the total, few believe that is either accurate or sufficient.
The banks have always done a poor job allocating capital, responding more to political pressure and an incentive structure which gives them every reason to favor faltering state owned enterprises with collateral over private enterprises that may have teeming order books but lack collateral and connections.
Hidden leverage remains a problem. Observers have long fretted about the tentacles of the shadow banks that now account for an estimated $3.6 trillion stock of debt. Yet none anticipated that the shadow banks would provide so much margin financing to investors, thereby driving the stock market up 60 percent in a matter of weeks to unsustainable levels. Estimates of the extent of that margin lending range from over Rmb2 trillion to as much as Rmb5 trillion but part of the problem of course is that nobody really knows. Like so much else in Chinese finance, there is little transparency.
All this points to a dire outcome. But it is not the entire story.
For a start, China could use monetary policy much more aggressively to ease the debt burden. The People’s Bank of China cut interest rates five times in 2015 in an effort to support growth and reduce the burden of debt for its over-leveraged borrowers. It is likely to cut further in 2016 and has room to do so, given deflation and high real rates. While nominally low, the real burden of rates is actually quite high given deflation of over 5 percent. And even a low rate is a burden for many industrial companies which are suffering from low or zero profitability. Third-quarter results of almost 1,400 Chinese A-share companies listed before 2009 show non-financial sector earnings plunging 37 per cent over the same period a year ago in the worst showing since 2010, Credit Suisse notes.
Second, a lot of the data overstates the downside. A focus on PMIs, industrial production, freight tonnage on the railways, or power consumption made sense when the China story was all about manufacturing. As these numbers fall, the panic grows. But that data reflects an ever smaller part of the Chinese economy. That is why JPMorgan’s chief China economist, Haibin Zhu, refers constantly to the mainland’s two-speed economy in which growth in services and consumption increasingly compensates for the shrinking role of manufacturing and exports (although the numbers for the tertiary sector's contribution to GDP were swelled for part of the year by the outsize contribution of the financial sector reflecting the frenetic months of stock buying).
As Zhu wrote in mid-December, “The economic structure of the China economy has changed notably.” According to Zhu, “The share of tertiary industry rose to 49.8 percent in the third quarter. By contrast the share of secondary industry has fallen to 34.1 percent.”
Similarly, Shan Weijian, the rainmaker at TPG Newbridge Capital and now at PAG, refers to the bad economy of China, which includes sectors like coal and metal mining and processing, paper and pulp, shipbuilding, cement, oil, gas and petrochemicals, and the good economy of China, which includes retail, tourism, healthcare, media and entertainment. The latter has to grow to offset the former, and that is what is happening. A chart that he presents to investors in his fund shows the line between the industrial sector and the service sector crossing, with services accounting for 52.5 percent of GDP in the first half of 2015, and the contribution of the industrial sector down to 42.6 percent in 2014. Moreover, as Shan points out, for a given unit of output the services sector is more labor intensive than manufacturing so that as demand for services increases, so does demand for labor.
Third, the alarm from the doomsayers is selective. For example, it ignores the huge gains that China has made in energy efficiency, which has allowed the country to reduce consumption without necessarily reducing output. In addition, while China’s trade surplus dwindles, its market share in global trade has actually risen, a feat that is all the more remarkable given that the currency has appreciated by as much as 50 percent against competitors such as Japan.
Reserves are indeed shrinking but that is partly by design and if anything points to a more balanced economy. And part of that loss is merely a change in valuation. In any case, those reserves are still more than adequate to deal with the problems in the financial sector. The government can easily recapitalize the banks and bail out both ailing local governments and state- owned enterprises by tapping China’s still ample reserves and its capacity to borrow if it so desires.
Indeed, demand for government debt can only grow now that the renminbi is part of the International Monetary Fund’s special drawing rights. Making its government bond market more liquid, transparent, and attractive necessarily follows on from that and means that there will soon be a bid for renminbi assets from most central banks.
Fourth, China continues to look far better than most of its indebted neighbors when it comes to its ability to service its debt. “China’s overall external indebtedness is limited and the debt servicing capacity of the country as a whole remains intact,” noted China International Capital Corporation in a recent report. “China’s foreign exchange reserves are still more than twice the size needed to cover all its external debt and four times its foreign currency debt.”
Moreover, the time-structure of the debt is improving, as Beijing is encouraging its local governments and corporates to issue more long term debt. For example, most of the financing by local governments in the shadow market that has given rise to so much alarm was expensive and short term. By encouraging the emergence of a local government bond market, the government is engaging in a kind of debt restructuring. It is turning that short-term expensive debt into ten-year obligations with a far lower interest rate.
In addition, Beijing has recently relaxed the rules on issuance in the corporate bond market in a move many believe was meant to offset the funding squeeze in the stock market. At the same time, the debt market can also help compensate for the reluctance of banks to lend more to clients whose cash flows have fallen with the slowdown in the economy.
As a consequence, bond issuance has surged. For example, companies raised almost Rmb900bn of debt in the third quarter — 56 per cent up on the same period a year ago, according to data from the CLSA arm of Citic Securities. Property developers, which have seen their cash flow dry up as the property market plunged, have been among the most active in taking advantage of favorable sentiment. Between mid-July and mid-October alone, 48 developers raised money in this market, Credit Suisse calculates. Much of that will go to refinance existing, shorter term debt.
Sometimes, it pays to have an under-developed financial market—there are simpler solutions that way.
Finally, there are many signs of a growing and vibrant private sector. Although China still needs to improve capital allocation to small- and medium-size enterprises, the private sector is now by far a larger source of jobs. To its credit, the government is allowing the private sector to flourish, and encouraging competition. For example, Tencent’s ‘WeChat’ application has killed the text messaging business of state- owned China Mobile, while Alipay’s higher paying internet money market accounts have sent a warning to Chinese banks to cease taking their depositors for granted.
To be sure, these things do not mean that all is well behind the Great Walls built to keep the barbarians and foreign hedge funds out. Capital outflows reflect more than just a belief that the yuan will no longer strengthen. The fact that China has relaxed its capital controls means that offshore the value of the currency is lower than it is onshore—and means that the government can no longer control the rate as tightly as in the past. There are gaps in the capital great wall.
Still, Beijing has never cared as much about the pace of growth as observers have. What matters to the leadership is job growth. And so far job growth has held up remarkably well, as noted earlier.
With the notable exception of a few provinces such as Heilongjiang and Liaoning in China’s perennially depressed northeast, China is one of the few countries in the world where incomes are actually growing, anywhere between 10 percent and 15 percent, making the probability that China will be able to transition to a post-manufacturing world at far higher wage and income levels than most other giants such as Brazil or India, despite its aging population. A laid-off worker from some withering state-owned enterprise today has more choices than in the past, finding a job say delivering goods for JD.com—and earning more at the same time.
So, life on the mainland in some ways is becoming fairer--but only up to a point. Income inequality remains a huge issue. The anti-corruption campaign has deep popular support precisely because the system is so inequitable. Not since Chairman Mao has any politician amassed as much power in his own hands as has Xi Jinping. The average citizen of China is deeply disillusioned with the Party. At the same time, many in the elite, (to whom the anti-corruption campaign is more about targeting opponents than stamping out corruption), are deeply disaffected with Xi himself.
Indeed, this points to what may be the greater risk in China. Today, the greatest danger facing China may be less about financial or economic stress than it is about social and political pressure.
China: It's Worse Than You Think
Richard Vague, Managing Partner, Gabriel Investments
Reprinted from Democracy Journal
China’s stock market tanked badly again last week, and is now down over 40 percent since June 2015. It might be easy to minimize this and conclude that China’s unwary stock market investors have now simply paid for their profligacy. It’s easy to think that China’s economy has just hit a bump in the road and will now endure a further slowing and perhaps a few of years of pain but remain on its path of good growth.
But it’s a lot worse than that as today’s Chinese GDP report suggests. China grew at a rate of 6.9 percent in 2015, its slowest pace in 25 years—only adding to mounting global concerns about China’s economy. My view is that this published rate likely overstates China’s actual current growth rate.
I wrote about China’s impending economic calamity back in 2014 in my book,The Next Economic Disaster, and elaborated on this prediction in an article in Democracy in February 2015. My analysis was centered on private (non-governmental) debt. Economically, what you need to know about private debt is that 1) when a country’s private debt to GDP ratio is low, private debt growth is especially effective in helping to power growth; 2) when that ratio gets higher and private debt grows too rapidly, the result is almost always a severe, calamitous financial crisis; and 3) the residual high private debt levels actually suppress growth since the private sector has to divert income away from investment and spending and toward paying down its private debt.
Runaway private debt growth (defined in larger countries as roughly 20 percent of GDP or more over five straight years) led to essentially all financial crises—including the 2008 crisis in the U.S. and Europe, Japan’s 1991 crisis, the Crash of 1929, and many others. Why? This runaway lending leads to so much overbuilding and overproduction that growth has to be severely curbed in order for demand to catch up, with far too many bad loans made in the process.
The analysis on China is straightforward. The runaway growth in private (non-governmental) debt in China from 2008 to the present dwarfs anything that has ever happened in global economic history. China’s private debt has grown by a massive $16.3 trillion, creating as much as $3 trillion in bad debt in the process. The result is a country littered with ghost cities and piles of commodities including iron and steel. The inevitable bust has begun.
But why will things in China continue to get worse? Because China hasn’t learned anything. China’s private debt growth has reaccelerated to a runaway pace—$805 billion during the last reported quarter alone—and China’s businesses are still overbuilding and overproducing, prodded and aided by China’s government itself. All on top of the years and years worth of overcapacity that already exists.
It’s unprecedented. With almost 50 million empty houses and with big inventories of major commodities, China’s lenders, builders, and manufacturers are still going for more. As one small example, the world, led by China, is still on track to produce as much as 40 percent more iron and steel than it needs this year.
Instead of curbing production and letting real, organic demand catch up with its oversupply—which is the unavoidable requirement to begin rectifying these problems—China is exacerbating this oversupply, ensuring that the eventual reckoning will be all the more difficult. The reason is that its primary concern has long been unemployment, and continuing to produce keeps people employed. Also, continuing to produce allows China to post better GDP growth numbers—they get GDP credit for building a house whether they sell it or not. And perhaps more telling, this is the only strategy China knows—it’s the same one they’ve been using for 30 years.
What will this pain look like? It will be a decade of downward pressure on non-agricultural commodity prices, a deceleration of China’s growth rate to a level near zero, the near-failure of lending institutions (though China has proved a master of propping up insolvent banks), and a potential acceleration of political unrest. If that isn’t enough, all will be accompanied by crisis or near-crisis throughout the Asia-Pacific region, Africa, and South America. In fact, the greater risk may be to all those economies that became dependent on Chinese demand, invariably building their capacity through high growth in private debt.
China is a big part of the oil equation as well, and its decelerating net demand for oil will likely keep prices in the $30 to $40 per barrel range, or lower for some time absent a full-blown war.
Stocks are generally a symptom rather than a cause, and the Shanghai Composite Index, with a price-earnings ratio of 16 (the Dow is currently at 14), has a valuation that is no longer in the stratosphere. However, grave uncertainty about China’s economy and the fragility of China’s corporate earnings, nestled inside the shaky foundation of Chinese accounting standards, could keep China’s stock markets in a troubled mode for some time.
The inevitable slowdown in China is made worse by the fact that there is no other major economy able to pick up the economic growth baton by expanding private debt. Together, the United States, Europe, Japan, and China add up to almost 65 per cent of world GDP. Runaway private debt growth led to Japan’s economic miracle of the 1980s and crash in the 1990s, and it still has residual high private debt levels from this boom that are stultifying its growth rates to near-zero levels 25 years later. Runaway private debt growth led to booms and then busts in the United States and Europe in the 2000s, and the residual high private leverage now impedes their growth.
Now China has had its private debt binge as well and is entering its bust phase. That means that all four of the world’s major drivers of global growth—the United States, Europe, Japan, and China—are now laden with private debt and are facing years of lackluster growth, ensuring long-term downward pressure on commodity prices and interest rates.
The United States will be the least harmed by China of all major countries, but China’s economy, now second largest in the world, is so large that we too will feel at least some of their pain.
The recipe to fix this is obvious. It requires widespread private debt restructuring, recapitalization of lenders, and then time itself to allow for demand to absorb this oversupply. But it goes unheeded—very few agree with or are focused on these things, and instead China is trying the timeworn (and futile) trick of attempting to stimulate continued growth through government intervention.
Fasten your seatbelt.
Diana set up Enodo Economics, an independent macroeconomic forecasting company, in 2016 to untangle complexity, challenge the consensus and make sense of the future.
For 16 years prior she worked at Lombard Street Research, most recently as their chief economist and head of research. In that role, she set the agenda for the firm’s team of economists and strategists while conducting her own global analysis. She joined LSR after completing her master’s degree in economics in 2000, and over the years has covered a wide range of developing and developed economies. Diana became a director of LSR in 2005 and headed the firm’s UK service from then until 2009. Between 2010 and 2013 she was based in Hong Kong overseeing LSR’s expansion in Asia.
She is best known for her analysis of China, including the book she co-wrote in 2011, ‘The American Phoenix – and why China and Europe will struggle after the coming slump’. Diana writes regular opinion pieces for the Financial Times, Wall Street Journal, Barron’s, etc. She has extensive global experience engaging with all manner of audiences and has made frequent television appearances, including on BBC’s Newsnight on the day that Lehman Brothers collapsed.
Yan Liang is an Associate Professor at Willamette University. She specializes in Post Keynesian-Institutionalist approach to international trade and finance, financial macroeconomics and economic development (with a regional focus on China). She received a master’s degree and a doctorate degree in Economics from University of Missouri-Kansas City. Professor Liang is an active member of the Association of Evolutionary Economics, Union for Radical Political Economics, and Association for Institutional Thought.
Christopher Balding is a former associate professor of business and economics at the HSBC Business School in Shenzhen and author of "Sovereign Wealth Funds: The New Intersection of Money and Power."
Henny Sender is chief correspondent for international finance at the Financial Times, based in Hong Kong.
Sender was part of a team at the Wall St Journal that won a Loeb award for coverage of the meltdown of Amaranth hedge fund. Her work on the overseas Chinese received a citation from the Overseas Press Club and she was a finalist for the National Magazine Awards. Her book on India was published by Oxford University Press.
Sender holds an MS from the Columbia University School of Journalism and is a member of the Council on Foreign Relations.
An excerpt from The Next Economic Disaster: Why It's Coming and How to Avoid It.
A World Economic Roundtable report on private debt and the American middle class.
How institutional design and austerity is destroying the European economy