02 September 2016
The most dangerous words in forecasting are ‘this time is different’. Throughout history, developing and wealthy countries alike have suffered from damaging economic downturns after a concerted phase of rapidly rising debt. And, given its trajectory in recent years, it’s easy to suggest China will follow.
Many observers agree China has more debt than it should for a country at its stage of development. But, as with most issues in China, there are many facets to the debt and liability story. These nuances lead us to believe it’s well insured from the traditional causes of emerging market financial crises.
Read our four qualifiers to China’s debt
While most of the attention has focused on China’s bank debt, which is far higher relative to GDP than US levels, the chart below shows its total liabilities are not excessive when all forms of finance are considered.
The bonds, equities and securitised loans that make up the majority of liabilities in the US system are presently an afterthought on China’s national balance sheet. Given this starting point, the Chinese authorities have the option to design policies that change the composition of its liabilities favourably, rather than reducing the level of overall liabilities: the desired composition being one that better reflects the assets being held. This could be done by promoting alternatives to traditional bank loans, such as equity and bond raisings, for new lending and re-financing. Existing loans could be securitised to help manage risks for bank balance sheets and provide a wider selection of assets for China’s burgeoning funds management sector, including the growing foreign contingent now participating actively in Chinese financial markets. Cumulatively, this would improve the pricing of risk, de-concentrate its exposure and ease pressure on the economy without overly constraining the availability of capital.
China’s directly held debt is concentrated on local governments (LGs) and state owned enterprises (SOEs). Both have options available to restructure their liabilities. LGs could privatise infrastructure assets to pay down debt while they build the tax base they need to balance their books over the long term. State owned companies could pay down debt with the proceeds of equity raisings.
Other major sectors have accumulated relatively little debt, either in absolute terms or relative to their assets or income. Chinese households have barely begun to access credit like western consumers, while they sit on both a very large positive equity position in real estate, and a massive pool of deposit savings in the banking system. Mortgage debt levels are still extremely low; and non-mortgage consumer credit, such as auto loans and credit cards, is still an immature industry. In the non-state corporate sector, private firms have cut their leverage ratios in half since 2007 according to the IMF.
Chinese households have barely begun to access credit like western consumers.
China is also a huge international creditor and retains enormous foreign reserves, notwithstanding a decline in its holdings over the last year or two. These international assets are mostly negotiable debt claims on foreigners that could potentially be sold at any time, and the proceeds repatriated. By contrast, foreign investment in China is mostly focused on physical assets that tend to pay attractive long run returns but are not so easily sold or repatriated.
China’s debt levels will remain a focus for those who want to understand how the Chinese and global economies might develop during a future period of stress. But as we argue above, China’s leadership can address the current imbalances in the composition of China’s overall financial liabilities before such an event occurs. How effectively they do this will determine whether this credit cycle will end differently.