China’s debt-to-GDP ratio has risen to unprecedented levels, stoking fears of a looming full-blown debt crisis. Such fears are reinforced by related economic risks: (a) a possible hard landing (b) excessive liquidity coupled with deflation (c) overcapacity and (d) sluggish international trade.
As China’s economy is beginning to show signs of stabilizing (Click here), fears of hard landing, and deflation, have largely receded, at least for now. Nevertheless, despite continuing efforts to rein them in, problems of overcapacity remain. Meanwhile, excessive liquidity is being ameliorated with surging outbound direct foreign investments and outflow of capital driven by expectations of a weakening RMB. This is partly reflected in China’s foreign exchange reserves, which peaked at nearly $4 trillion in June 2014 and fell to about $3.2 trillion by January 2016.
Against this backdrop, I now focus on China’s debt problem.
According to a recent McKinsey report, the level of gross debt in 2014 was 282% of GDP. This includes government debt (55% of GDP) and debt owed by financial institutions (65% percent of GDP), nonfinancial corporations (125% of GDP), and households (38% of GDP). Recent estimates suggest that corporate debt may have risen above 150% of GDP by early 2016.
China has traditionally had a low level of foreign-currency external debt. At $800 billion or 7% of GDP in 2015, it is much lower than virtually any other major emerging market.
China has an exceptionally high level of corporate deposit holding, equivalent to 90% of GDP, compared with 7% of GDP in the United States. Albeit a sign of low efficiency of capital utilization, loans are often recycled back to the lending bank as deposits. Nevertheless, this enables the banks to earn high interest spreads and acts as a cushion against exigencies. According to the People’s Bank of China, at the end of 2014, total bank deposits amounted to some US$19 trillion while total loan book stood at US$14 trillion. 45% of the bank deposits came from personal savings while 50% came from enterprises.
China’s household debt (and gearing) remains comparatively low. Housing price inflation and speculation notwithstanding, the contention of a massive mortgage crisis is not borne out.
Despite rise in credit volumes, China’s economy is not over-indebted while the government possesses adequate capacity to absorb losses. There are also massive private savings, offering scope for the corporate sector to undertake debt-equity swaps.
Non-performing bank loans (NPA) are estimated to range from 6–7% to as much as 25% for some smaller banks. However, unlike those in the West, thanks to “financial repression” limiting deposit interest rates, Chinese banks derive a vast proportion of their funding and profits from stable bank deposits, rather than loan spreads. Moreover, China’s banks are mandated to have about 17% of required reserves at the People’s Bank of China. By way of further insurance, a bank deposit insurance program has been in operation since May 2015.
The balance sheet of the government as a whole is healthier than sometimes surmised. The state has a treasure trove of assets—including its massive foreign exchange reserves, ownership stakes in the state enterprises, and foreign investments through the sovereign wealth fund.
A look at McKinsey Global Institute’s Debt-to-GDP Ratio -Country Ranking in 2Q 2014 may help to offer some perspective. At 217%, China ranks only 22nd out of 47 countries, compared with the following countries in the top ten rankings - 1. Japan (400%) 2. Ireland (390%) 3. Singapore (382%) 4. Portugal (358%) 5. Belgium (327%) 6. Netherlands (325%) 7. Greece (317%) 8. Spain (313%) 9. Denmark (302%) 10. Sweden (290%).
Moreover, a significant proportion of China’s debt, particularly at the local government level, is going into building infrastructure for the largest and fastest urbanization drive in human history. The aim is to turn China into a middle-class country, with long-term social, economic and political benefits. These loans cannot be adequately evaluated on purely commercial terms.
As for State Owned Enterprises, risks should not be based solely on liabilities. Taking into account their massive asset base, their loan-to-equity ratios do not appear excessively-geared (Click here).
The IMF computes a measure of augmented public debt, which includes various types of local government borrowing, including off-budget borrowing by Local Government Financing Vehicles (LGFVs) via bank loans, bonds, trust loans, and other funding sources. By this measure, China’s public debt to GDP ratio is estimated to be 60% in 2015, still below the public debt to GDP ratios of major advanced economies.
Moreover, China’s net foreign assets amounted to $1.6 trillion at the end of 2015, more than enough to cover all of its foreign liabilities.
The picture would not be complete without addressing the related problem of shadow banking.
According to a Brookings Institution Paper in May 2015 (*), China’s shadow banking stood at RMB 25 trillion, or 43% of GDP, in 2013. According to a research paper (16 March, 2015) of the Fung Global Institute, a Hong Kong-based think tank, at the end of 2014, China’s total shadow banking exposure rose to RMB 32.2 trillion, or 51% of GDP. This compares with a global average of 117% of GDP.
Despite its rapid growth, shadow banking, however measured, remains substantially less important than formal banking as a source of credit in China. Nevertheless, the Chinese central government has taken important measures to tackle this issue in recent years.
In October of 2014, a directive entitled “The Directions of the State Council on Management of Local Government Obligations” outlined a framework and principles for regulating how local governments raise, use and repay their debts. In the beginning of 2015, the Ministry of Finance (MOF) approved a local debt swap scheme with a quota of RMB 3 Trillion. Under this scheme, each provincial government is able to sell low-interest local bonds directly to commercial banks to replace high interest debts obtained from shadow banking channels. A quota of RMB 1 trillion has been allocated to the provincial level as of the first quarter of 2015.
China’s shadow banking sector is not especially large by international standards and is relatively unsophisticated, with low levels of instruments such as securitized assets and derivatives. Regulators remain alive to the most important risks, namely funding risk and lack of transparency and have taken prudent steps to minimize them.
In sum, China’s financial system is a work in progress with many reforms and challenges outstanding. This translates to a relatively low level of capital efficiency. However, as pointed out by Eswar Prasad, Senior Fellow at Brookings Institution during his testimony before the U.S. China Economic and Security Review Commission on 27 April 2016, China’s debt problem, whilst serious, presents no systemic risk and is largely manageable. (4)
(*) By Douglas J. Elliott, Fellow, Economic Studies, Initiative on Business and Public Policy and Dr Yu Qiao, Nonresident Senior Fellow, Foreign Policy, Brookings-Tsinghua Center, Beijing, PRC.
An abridged version of the above analysis appeared in the China Daily, European Weekly, 25 November - 1 December, 2016. Click here