A leading cause for concern over the health of China’s economic prospects is its debt burden. Since writing about this topic last year, I’ve received many questions from investors, so in this issue of Sinology, I share my responses to those questions.
The debt problem is serious, but the risk of a hard landing or banking crisis is, in my view, low. The key reason for that is that the potential bad debts are corporate, not household debts, and were made at the direction of the state—by state-controlled banks to state-owned enterprises. This provides the state with the ability to manage the timing and pace of recognition of nonperforming loans. It is also important to note that the majority of potential bad debts are to state-owned firms, while the privately owned companies that employ the majority of the workforce and account for the majority of economic growth have been deleveraging. Additional positive factors are that China’s banking system is very liquid, and that the process of dealing with bad debts has begun.
Cleaning up China’s debt problem will be expensive, but this process is likely to result in gradually slower economic growth rates, greater volatility, and a higher fiscal deficit/GDP ratio, not the dramatic hard landing or banking crisis scenarios that make for a sexier media story.
Now, to your questions:
Q: Everyone agrees China faces a serious debt problem. How did this problem develop?
The origin of China’s debt problem was the 2007 to 2008 Global Financial Crisis (GFC). Prior to that point, China’s debt/GDP ratio was relatively low and stable.
The GFC led to a collapse in global demand for goods, including exports from China. As Chinese exports collapsed, many factories closed and an estimated 20 million workers lost their jobs. The government was concerned that this spike in unemployment—primarily of young workers who left rural homes for urban manufacturing jobs—might lead to social unrest.
But the government rejected the idea of a large currency devaluation because the problem was lack of demand in markets such as the U.S. and Europe, not weak competitiveness of Chinese goods.
Instead, Beijing undertook the world’s largest Keynesian stimulus: spending government money to accelerate the construction of public works projects—everything from bridges and roads to wastewater treatment plants—that had been scheduled to be built in the future. The objective was to quickly create millions of jobs, ranging from construction and driving to accounting, in an effort to reduce unemployment and the risk of social instability.
Q: How did China pay for this stimulus?
In most countries, a huge stimulus like this would have been funded directly by the government via fiscal spending. China, however, chose to fund its infrastructure construction stimulus via bank loans.
Back then, officials told me they preferred to use bank loans because every bank in China was (and still is) controlled by the government, and most of the loans went to state-owned enterprises (SOEs) who were responsible for managing the construction projects (although much of the work was carried out by privately owned contractors). Officials said they hoped a network of bank branch managers could be held responsible for ensuring that construction proceeded rapidly with a minimal level of waste, fraud and mismanagement.
Q: Was the stimulus a success?
By some metrics, the stimulus was very successful. Most importantly, from the Chinese government’s perspective, the stimulus created enough jobs to help the country weather the GFC without significant social unrest.
Also, China’s debt was the result of spending on public infrastructure, which is a sound, long-term investment, helping reduce poverty and raise productivity. China has more than 150 cities with populations over 1 million, and before the stimulus many of them lacked the infrastructure necessary to support good manufacturing and services jobs.
From an international perspective, the stimulus was also successful in that it put a floor under global economic growth: in 2009, China off-set most of the decline in global growth from the U.S., E.U. and Japan. In 2015, China accounted for about 35% of global growth.
But the jump in lending to finance the GFC stimulus was also the root cause of China’s current debt problem. As the next chart illustrates, in the years immediately prior to the GFC, China’s debt/GDP ratio was relatively stable at about 150% of GDP. That ratio jumped dramatically in 2009, as the stimulus was deployed, and continued to climb until reaching about 255% of GDP last year.
Q: It sounds like China’s debt/GDP has reached a scary level?
China’s overall debt/GDP ratio rose rapidly after the GFC and is very high, but not so scary in context: it is lower than the debt/GDP ratio of five of the G-7 advanced economies.
Q: Do Chinese consumers have a debt problem?
Understanding the composition of China’s debt is important to understanding the seriousness of the problem. A key factor is that the Chinese household debt/GDP ratio is fairly low, about 40%, compared to 80% in the U.S., 90% in the U.K. and 60% in the Euro zone.
Moreover, the largest share of Chinese household debt is home mortgages, and these are far safer than the mortgages that created significant problems in the past decade for households in the U.S. and U.K. For example, about 90% of new homes in China are bought by owner-occupiers (not speculators) who are required to pay a minimum of 20% cash to receive a mortgage—far from the U.S. median cash down payment of 2% of the purchase price in 2006.
The products that broke Lehman Brothers—and caused havoc throughout the U.S. financial system—do not exist in China. There are no sub-prime mortgages and there are very few mortgage-backed securities. There is no secondary securitization so no collateralized debt or loan obligations (CDOs and CLOs).
This is an important distinction from the pre-GFC period in the U.S., where there was a steep increase in consumer debt, especially in sub-prime mortgages, and the “enormous rise in residential mortgage foreclosures soon developed into a full-blown financial crisis and led to one of the sharpest market contractions in U.S. history. While many trends in the financial system played a role in these developments, household behavior was clearly a fundamental contributor,” according to a study by the Federal Reserve Bank of New York.
It is also worth noting that in addition to a relatively low household debt/GDP ratio of 40%, Chinese families have a very high savings rate, with household bank deposits equal to about 80% of GDP. In the U.S., the household debt/GDP ratio is 80%, while household (and non-profit organization) savings deposits are equal to 46% of GDP.
The absence of a large consumer debt burden should make China’s overall debt problem much easier to manage, and make the debt reduction process much less painful.
Q: How bad is China’s corporate debt problem?
China’s real problem is corporate debt. The ratio of non-financial corporate debt/GDP jumped to 127% from 97% in the three years after the stimulus began, and then continued