Here is what’s wrong with debt in China: too huge, built-up too fast, and hard to count.
Huge compared to produced goods:
Although economy has grown at 6.9% in Q3 y-o-y, yet bank loans increased by 15.4% in Q3 compared with the same period in 2014. China’s overall debt-to-GDP ratio is continuing its steady upward march.
Growth in credit did slow down. Measured by total social financing (TSF) growth (bank loans + corporate bonds + shadow lending) soared to 35% in 2009, but rose by 13% this quarter from a year earlier. But what is important is to see how much debt is rising vis-à-vis GDP, to truly measure indebtedness.
In 2007, debt was 160% of GDP. Now the ratio stands at more than 240%, 161 trillion yuan ($25 trilliion). That’s almost double the buildup in debt in the US and UK in the run-up-to the financial crisis.
Here is the graph that Bloomberg produced based on McKinsey numbers:
Hard to count:
The sheer pace of new lending, regulatory loopholes, shadow banking practices, and a murky system of implicit guarantees (not clear whether debt is backed by the government or who would be allowed to go bust)
Since most of the debtors are state-owned companies and creditors, state-owned banks, the Chinese government can still control the situation. It has done so by simply rolling over non-performing loans when they are due, or extend the deadline.
SOE and finance reform central to reducing debt:
However, that only spares the economy of an eventual reckoning in the short-run. And in addition, when there is a need for loans to be distributed to soft-land growth, a lot of it is still being funneled to zombie corporations rather than the enterprising private sectors.
This situation has got worse. 6 years before the crisis, one yuan of credit brough 5 yuan of national output. Now that ratio has come down to 1/3.
Indeed, central to reducing debt is restructuring old and unproductive SOEs as well as overhauling a financial system which continues to favour these at the cost of new, full-of-potential companies that will precisely be the new drivers of growth.
What has the government done so far?
The government should bravely have pulled the plug on these old SOEs continuing to extend loans and not letting them go bust (the power equipment maker Baoding Tianwei, and Kaisa Group which has failed to pay overseas bonds) apart from but it hasn’t done so because it fears of social unrest and the toll it might take on.
It has so far tried to get a clearer picture of liabilities:
- – require local government to compile and display better data on debt.
– force banks to bring more of their shadow loans onto balance sheets (they have made more official loans to substitute shadow loans)
It has also used monetary easing and low cost bonds (longer payback periods)-swap program (2 trillion yuan worth of high-interest debt) for local governments to reduce cost serving debt.
One problem is the last solution. People think this is just brushing the problem else where. Net bond issuance in first nine months of 2015 was 8.7 trillion yuan, up 67% y-o-y. More on bonds later.
Optimism and Pessimism:
Optimists say companies and local governments will simply grow their way out of the problem with an expanding economy. As China continues to grow (still at 6 something %, it will need additional projects; one road one belt, though by itself will not be enough). And the Chinese government has plenty of money to cover bad debt.
They also pluck on specific types of debt. The ratio of debt to equity for listed companies, for instance has peaked at 159 % in the middle of 2012, aand has started to edge down. It’s some distance away from the 234% in the US just before the Lehman collapse. Additionally, while those in the old economy do indeed have excess credit, with close-to zero return on assets, those in the new economy like e-commerce Alibaba are more innovative, cater to consumers, post much less debt to equity ratios and more impressive return on assets. The private sector is outpacing state sector in output, profits, and employment. Service sector’s contribution to GDP has been bigger than manufacturing since 2013.
But pessimists say risks are mounting as China’s economy cools and slower inflation threatens to make debts harder to repay. The Chinese government does have an unusually strong fiscal firepower and can bailout everyone. But high debt can drag on growth, like it did on Japan and Europe. IMF puts the drag-on-growth threshold at 96% of GDP.