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Satyajit Das: China's Debt Chickens Are Coming Home to Roost


Observers worry whether high debt levels, increases in borrowing, and servicing problems will result in an economic crisis.

China has had a 35-year addiction to cheap credit, which is now coming home to roost.

The 2007/2008 global financial crisis (GFC) 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. The recovery has been driven by a significant expansion in credit, known as TSF (total social financing).

Post-GFC, new lending by Chinese banks has been consistently around 30% or more of GDP. Around 90% of this lending has been 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."

This expansion led to a rapid increase in the level of debt. 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.

But the official Chinese government debt figure may not be complete, as it may exclude debts from local governments and central departments outside of the Ministry of Finance. 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.

Corporate debt has increased sharply, approaching 150% of GDP. Traditionally considered compulsive savers, Chinese households have increased borrowing levels from around 20%-30% to 40%-50% of GDP. Inflation has driven increases in household borrowing, with sharply higher home prices requiring greater borrowings and devaluation of purchasing power encouraging debt-fueled consumption.

Debt Metrics

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.

The rapid rate of increase in debt is also concerning. An increase in debt of around 30% of GDP in five 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 2000s -- experienced such rapid growth in credit, resulting in serious financial crises. China has experienced a similar expansion in debt.

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 needs 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 needed for each dollar of growth eight to 10 years ago.

In China, debt has primarily financed investment but increasingly funded purchases of existing assets, which doesn't add directly to economic activity. Investment in new assets is heavily focused on frequently large-scale infrastructure and property. The major concern is that many of the projects won't generate sufficient income to service or repay the borrowing used to finance the investment.

Increased debt-fueled 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 southwestern 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 that are financed have 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 (DSRs) 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, 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 on 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 one year, requiring refinancing at the start of each year. As few Chinese borrowers have sufficient operating cash flow to repay loans, 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.

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.

Debt Mood Swings

Pessimists are concerned about a catastrophic crash. Optimists are more sanguine, expecting a soft landing with gradual reforms correcting the systemic issues.

The crash scenario is predicated on continuing increases in debt levels and overinvestment. Policy adjustments are fatally delayed. Ultimately, authorities are forced to tighten credit, aggressively triggering failures in the financial system and a sharp slowdown in growth.

Weaknesses in financial structure exacerbate the money-market tightening, causing liquidity-driven problems for both vulnerable smaller banks and the shadow banking entities. The rapid decline in credit availability results in problems for leveraged borrowers, such as those in local governments and property sectors. The larger banks, which are likely to benefit from the flight to quality, are unable or unwilling to expand credit to cover the shrinkage from smaller banks and the shadowing banking sector, due to risk aversion or regulatory pressures.

The deceleration in credit growth and liquidity results in lower levels of economic activity. Foreign capital inflows -- which have enabled the People's Bank of China (PBOC), the central bank, to provide liquidity to the financial system -- slow and then reverse. At the same time, capital outflows (especially from corporations and also the politically well-connected and wealthy) increase, driving further contraction in credit.

The optimists counter that the debt levels, while high, are manageable because of high growth rates, the domestic nature of the debt, high savings rates, and the substantially closed economy. They argue that the banking system has low leverage, a large domestic funding base, and low levels of nonperforming loans. They also rely on the high level of foreign exchange reserves and modest levels, at least by developed country standards, of central government debt.

The optimists believe that reform programs, albeit slow in implementation, will ensure a smooth transition. China will rebalance its economy from investment to consumption. Deregulation and structural changes will improve the resilience of the financial system.

The Middle Kingdom's Middle Path

The central government is seeking to steer a middle path, which is both difficult and has significant risks. The strategy will entail continued credit expansion, providing liquidity, managing nonperforming assets, and using transfers from households to the financial and corporate sector.

The central bank will continue to provide abundant liquidity to the financial system through a variety of mechanisms. Chinese authorities subscribe to the theory that "a rolling loan gathers no loss." Authorities have altered regulations to allow local governments to issue public bonds for the first time in 20 years.

Defaults in shadow banking will also be managed. Where considered appropriate, banks and state entities will intervene to minimize investor losses by taking over the loans or reintegrating assets into regulated banks. As in previous Chinese episodes of bad lending, nonperforming loans (NPLs) will be sold to existing asset management companies (AMCs), established to deal with previous banking crises, to avoid a banking crisis.

In effect, instead of resolving the debt problems, the Chinese government will oversee a process of supporting overindebted borrowers and the banking system. As in a shell game, bad debts will be shuffled from entity to entity, delaying the recognition of losses.

The ultimate price of this strategy will be to lock the Chinese economy into a lower growth path with the risk of a destabilizing crash. Over time, increasing amounts of capital and resources will become locked into unproductive investments that don't generate sufficient returns to service the debt incurred to finance it. The cost will be shouldered by households, with slower improvement in living standards and erosion of the value of their savings.

Authorities will have to keep saving rates high to provide the capital needed to pursue this strategy. They will ensure that the bulk of funds remain in the form of low-yielding deposits with policy banks, which can be directed by the central government as required. Interest rates will remain low below inflation. Banks will need to maintain a large spread between borrowing and lending rates to ensure sufficient profitability to absorb the cost of nonperforming loans. Borrowing rates and the cost of capital will also need to be kept low to support the investment strategy and also reduce pressure on unprofitable or insolvent businesses.

The loss of purchasing of household savings will provide the economic basis for the transfer of resources (amounting to as much as 5% of GDP) to banks and to borrowers, primarily SOEs and exporters. The necessity of high saving rates will impede the rebalancing from investment to consumption. It will also impede the development and deepening of the financial system. China will also have fewer resources available to improve health, education, eldercare, and the environment.

In the short run, continued malinvestment and deferring bad debt write-offs will provide the illusion of robust economic activity. Over time, households will discover that the purchasing power of their savings has fallen. Wealth levels will be reduced by the decline in the prices of overvalued assets. Businesses and borrowers will find that their earnings and the value of their overpriced collateral are below the levels required to meet outstanding liabilities.

China's Potemkin economy of zombie businesses and banks will create progressively less real economic activity.
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