Chinese debt poses great risks, require an overhaul of the financial sector, and demonstrate the need for a new growth model.
The quarterly report of the Bank for International Settlements paints a worrisome picture of the financial sector in China. The credit-to GDP-gap recently reached an extreme of 30 per cent – the highest level in the 21-year history of the series and the highest current reading of any of the countries monitored by the BIS. Credit expansion and credit growth is three times higher than it should be, given the size and growth of the overall economy – an extremely worrisome trend. Both the 1997 Asian Financial Crisis and the 2007 Real Estate Crisis were preceded by similar rapid credit expansions. In China now this value is even higher. While a central bank monetary stimulus in mid-February seems to have largely alleviated investor concerns, the underlying credit problem has not been addressed.
The IMF issued a warning for China in June urging the government to counteract the country’s high levels of corporate debt. This trend could dampen economic growth or trigger a new banking crisis – or both, as debt problems of companies could easily become systemic debt problems of the whole economy. The government is thus very aware of this risk and is trying to steer the economy away from further debt-financed growth path to avoid a banking crisis. However, the BIS report shows that the government’s toolbox is nearly exhausted: not only are corporate and private debt already at unsustainable levels, but China’s ability to service its debts is weak compared to other countries. According to a recent Reuters analysis, roughly a quarter of all Chinese companies earned too little to service their debt in the first half of 2016. Among other large emerging markets, only Brazil is weaker.
With corporate debt at 145% of the Chinese GDP – the largest share belonging to state-owned enterprises – a multi-dimensional approach would be necessary. This would entail tackling weak corporate governance in SOEs while using monetary and fiscal tools to get the debt level in control. Taking all forms of private debt together, China reaches a level of 169% of GDP; if public debt is included, China is between 250 to 315% of GDP.
Financial and social considerations
The guidelines that the government issued in October to reduce the debt burden are a very orthodox multi-pronged approach to cutting company debt, and include encouraging mergers and acquisitions, bankruptcies, debt-to-equity swaps and debt securitization. Yet problems persist with loss-making zombie-companies that might use debt-to-equity exchanges stay in business. Likewise, it is unclear how the government can avoid moral hazard problems without cutting into the interests of powerful but indebted SOEs. It is similarly unclear how debt-equity swaps would do anything more than shift risk from non-financial firms to banks.
There are social considerations to be taken too: when China experimented with debt-to-equity swaps in the late 1990s as part of reforming the state sector, around 28 million people were laid-off over five years. Given that the government legitimizes itself by guaranteeing nearly full employment, similar mass unemployment could threaten the very foundations of the country’s stability.
China’s banking sector needs reform
The underlying problem of these issues is that bond markets operated on the assumptions that issuers were guaranteed by the state – or the People’s Bank of China. Changing this perception without upsetting the markets is a mammoth task for the central bank when trying to create a favourable monetary policy for debt-reduction. At the same time, the People’s Bank of China needs to overhaul its own policy of reducing loans to ordinary banks and instead lending to large SOEs. This lending allowed SOEs to roll over existing debts and continue uneconomical operations. At the same time, this diversion of funds to SOEs forced private sector firms to seek higher-cost loans from the shadow banking sector, fueling the credit to GDP ratio.
There is no easy way out of this conundrum: either China must let growth slow by reining in credit growth, or it must keep accumulating debt in order to bolster short-term growth; thereby risking a financial crisis in the medium-term. China, like Eurozone and much of the rest of the world, has thus reached a point where central banks are expected to shoulder too many burdens.
Due to the ever-increasing role of central banks in restructuring the financial sector (China) and keeping the economy running (Eurozone), the dependencies between markets and central banks are strengthening. A case in point is the reduction of FDI to China after the very opaque decisions of the People’s Bank of China earlier this year or the stock market fluctuations after the ECB didn’t widen its purchase program while recommending the FED moderate interest rate rises. This means that central banks have shouldered too much burden for too long. At the same time, structural reforms were lagged behind, fueling potential devastating bubbles. The times were policymakers could turn to infrastructure and residential construction projects to help bolster economic growth are definitely over.