How Much Debt Is Too Much in China?

Markets and economic commentators are currently fixated on China’s rising debt levels and seemingly bottomless economic slowdown. Many warn of an imminent collapse. The argument typically begins by pointing out that China’s debt-to-GDP ratio has surged since 2009 at a pace comparable to the others who ended up experiencing a crisis. As these uber-bears argue, why not China?

Yet the argument that China is about to fall off a financial cliff is overstated. China simply does not fit that pattern. It possesses a strong balance of payments position, modest fiscal deficits, and high household savings rates. Moreover, the dynamics of a debt crisis are different for financial systems which are largely private compared with China where the bulk of the debtors are state-owned entities borrowing directly or indirectly from state-owned banks.

Although there are many anecdotal examples of financial stress, there is little evidence of widespread insolvency among Chinese firms and local governments that could threaten the broader economy. Nevertheless, the debt burden has increased beyond prudent levels and if not stabilized within the next several years, would exacerbate financial pressures and dampen longer-term growth prospects. Thus the failure for the authorities to take more decisive steps so far is worrisome even if warnings of an imminent crisis are overdone.

The clearest area of concern for China is corporate debt, with the rapidly increasing size of China’s corporate debt setting it apart from other countries. But much of this surge is concentrated among a narrower subset of firms in construction and property development and in the commodity and energy sectors. The more egregious cases tend to be large SOEs which will in some cases require consolidation, mergers, and bankruptcy.

But the oft cited risks of shadow banking are not as serious as many have argued. Most importantly, in all but the most extreme scenarios, the government has the flexibility in the form of discretionary fiscal and financial resources to bail out the most important distressed entities and to recapitalize major banks. This will ensure that any tensions do not turn into the sort of systemic financial crisis that could derail the economy.

The stabilization process, however, will be messy and costly as the economy slowly hemorrhages financial resources and throws good money after bad to keep growth in line with official targets. China’s inexperienced new investor class also may react to market stresses in unexpected ways. Adjustments in an overbuilt property market will exacerbate vulnerabilities. And, the recent surge and then collapse of the equity market has accentuated market perceptions about increasing risks.

These issues point to China’s need for reforms to slow the growth of bad debt and encourage productivity growth. While most observers see the crux of the problem emanating from banking vulnerabilities, its origins actually come from China’s weak fiscal system and limited financial markets. Local governments have relied excessively on banks and land development to fund infrastructure that should have been supported by the budget. SOEs need to rely more on non-bank sources of financing but currently China’s equity and bond markets lack the depth and credibility to play effective roles. The financial stresses are symptoms of underlying distortions and institutional weakness that still need to be addressed.

The size of China’s debt is worrying, but what is more worrying is its composition, i.e. the percentage of debt that goes to low efficiency entities. China’s non-financial SOEs alone have debt that is close to 120 percent of China’s GDP, and SOE borrowing is currently growing at nearly 20 percent annually. For the economy, allocating capital to inefficient borrowers means lower productivity and economic growth. For investors, this means they might not get their money back. There is clear empirical evidence showing that SOE return on assets has been rapidly declining in recent years. Therefore, at least SOE debt is already too high.

At first, it seems the central government doesn’t have much in debt. However, we should not overlook Beijing’s contingent liabilities. In addition to its responsibility to bail out SOEs, Beijing also fully backs the debt of China’s three national policy banks and all high-speed rail investments. On top of that, China also has a very large unfunded social security liability, which the IMF estimates to be around 70 percent of 2014 GDP for the period of 2015-2050. Therefore, it seems the entire state sector already has too much debt.

Instead of saying China’s households have room to increase borrowing, I would rather suggest that Chinese people know what is best for them and the current level of consumer debt is appropriate. Similar logic applies to the private sector as a whole.

Aggregate debt is the sum of state, household, and private sector debt. Since the last two seem reasonable while the first one is too large, it is fair to say China may already have too much debt.

Can China just muddle through without serious reform? This is probably possible in theory, but perhaps only in theory. On the one hand, Beijing still has more tools and resources than many other countries. On the other hand, capital outflow effectively constrains Beijing’s ability to muddle through. In the case of debt, muddling through simply means letting Chinese savers to share the burden. Whenever the government tries to “tax” savings, people will simply save less and move their money abroad. If too much burden is placed on savers, then it will lead to high inflation and capital flight. Beijing has already had a taste of capital flight, and the recent surge in real estate price is primarily driven by the expectation of further credit expansion. Even if Beijing tries to scale back some of the capital account liberalization measures, it would still not be enough to stop Chinese capital from seeking better opportunities abroad. Therefore, Beijing is constrained on the extent of financial repression without triggering a crisis.

Previously, rapid economic growth had helped Beijing in getting rid of debt. Nominal GDP tripled from 1998 to 2007. But this time economic growth will play a much smaller role as China’s potential growth rate is significantly lower. In addition, this option is not available for many over-capacity sectors that need to shrink their aggregate size.

How much Chinese debt is too much? The amount that helps prevent painful reforms. In this light, there is already too much debt.

The Chinese debt problem that some in the U.S. discovered in 2015 was guaranteed by Beijing’s panicked response to the global financial crisis in 2009. Responding to sharp contraction in demand with the biggest credit stimulus in history was a terrible mistake, even if many failed to see it.

Yukon Huang is correct that an acute debt crisis due to debt is many years away. In terms of yuan-denominated debt, the financial system is non-commercial—institutions do not fail despite continuous losses and cannot be directly attacked by speculators. While China’s accumulation has been faster, Japan has endured a huge and growing debt burden with no crisis, and Tokyo has less control of the financial system.

In terms of foreign exchange, there was a firestorm of world attention when outflows accelerated in August last year. But that and a second round of outflow in January were due largely to poor exchange rate policy. Beijing tried to adjust the dollar peg without communicating clearly its desired valuation and the uncertainty caused yuan-holders to sell. Barring another mistake of this magnitude, outflow will be minor.

What the pace of debt accumulation does signify is ongoing policy failure. The typical phrase “the central government has abundant fiscal resources available” is better rendered as “the central government has plenty more money to waste.” It is true, but in the same sense that a person who is 50 pounds overweight can likely manage to be 100 pounds overweight.

Defenders of China frequently talk about its claimed GDP growth still being world-beating, in terms of announced rate or annual increment. This borders on preposterous. If China were actually enjoying productive growth, debt ratios would be falling. What is predominantly occurring are debt-driven transactions with negative net returns. On Credit Suisse’s tabulation of net private wealth, China has underperformed the world since 2011, which is more representative than government GDP reports.

The only solution to rising debt and slowing growth is deep pro-market reform. This is not the empty rhetoric of the 2013 plenum. It is not the minor steps that bulls tout as transformative. It must feature shrinking the state sector (not amalgamating it). It must include movement toward full labor mobility as the work force shrinks due to aging. It should include private ownership of rural land.

There are obvious political challenges to the needed reforms and the most destructive effect of debt in the short term is to help paralyze Chinese decision-makers. Hugely beneficial financial competition is frightening because the most highly leveraged institutions would see funds flow to rivals. More broadly, the anchor on growth provides an excuse for decision-makers to attempt yet more stimulus, running up more debt in the process.

There is little threat of a crisis and yet there is already far too much debt. China is stagnating and debt is the single biggest reason why.

Perhaps the issue of China’s debt is only partly about economics, I believe it is mostly about politics. Certainly the mounting debt poses no immediate danger to the economy. China has huge reserves, trade surplus, administrative barriers against free outflow of capital and still quite a large GDP growth however we want to account for it. But it would be also naïve to ignore the growing mountain of debt and its underlying cause—the inefficient State Owned Enterprises (SOEs) dragging down the Chinese economy.

I wrote extensively elsewhere about it (see here and here). In a nutshell: SOEs must be privatized. All other measures, including the recently proposed debt-for-equity swaps, are palliatives that can gain some time but ultimately will worsen the situation. Who decides what SOEs’ debts to swap and what SOEs should simply be closed? These decisions, clearly out of the market and taken by some official eager to save his career, leave huge room for mistakes, waste and corruption. These all are elements that complicate the matter and do not solve it.

China, unlike Eastern Europe at the time of the fall of the Soviet empire, has capital and capitalists to carry out this privatization. Therefore, to decide to move on with it is only a political decision, as it would change deeply the nature of the country.

Will the party do it? We don’t know, there are many vested interests sucking on the tits of underperforming SOEs. But we know that in a few years this mountain of debt will weigh even more on China’s economy and might become an issue of life and death for the party and for China.