China’s debt: from diagnosis to treatment
Aidan Yao, economist emerging Asia at Axa Investment Managers (AXA IM) comments on the challenges of Chinese sovereign debt.
Debt bonanza has gone too far
China’s high and still growing debt level is commonly seen as a major threat to its economic and financial stability. By our estimate, the total debt level rose to 236% of GDP by mid-2014, up almost 70ppts from before the global financial crisis.
Recent literature suggests such a rapid debt build-up often serves as a precursor to future financial stress. Indeed, concerns about an imminent bursting of the debt bubble have grown, and the fear is that China could experience either a US-style financial crisis, where leverage is unwound abruptly, or a Japanese-type slow-motion correction that takes the economy into a prolonged period of subdued growth. Either way, the shock could be so severe that it may halt China’s economic convergence and plunge the country into a mid-income trap.
Given the severity of such a potential outcome, it is important that we gain a deeper understanding of China’s debt dynamics. This knowledge can help us to better comprehend the steps the government is taking to deal with the leverage problem. Overall, we think that with a strong commitment to structural reforms and substantial rescue
capacity in the official sector, China can avoid the painful and unsuccessful deleveraging experienced by many
Diagnosing the debt problem
There are some important characteristics of China’s debt dynamics that need to be understood before we can find the
right cures. We focus on debunking the debt conundrum.
1) Growth of debt is the true problem, as the level of debt is still manageable. At 236% of GDP, China’s total debt level is not excessive compared to many large industrialised nations. While it is high among
emerging-market (EM) economies, the vast majority of debt is locally owned and RMB-denominated, which helps
to insulate China from a classic EM debt crisis. China’s total gearing is slightly higher than what would be consistent with its level of economic development. But such a gap, when managed carefully, can be unwound without financial distress.
China’s debt to GDP ratio rose by almost 70ppts between 2007 and 2013. The only countries that experienced faster leverage accumulation were the European peripherals, which by and large are still mired in economic and financial struggles. China’s rapid increase in leverage was driven by a combination of structural and cyclical factors. Structurally, controls on bank deposit and lending rates have historically reduced borrowing costs in the economy. This has created incentives for corporates to borrow and invest excessively, at the expense of depositors.
The bias towards excessive borrowing worsened from 2009, when the government implemented a massive investment-driven stimulus, financed mostly by debt. In subsequent years, a huge amount of credit was channelled into unproductive sectors of the economy, fuelling substantial overcapacity in real-estate and industrial sectors. Inefficient usage of credit, combined with considerable slippage, resulted in GDP growth failing to keep up with debt growth, lifting the overall debt ratio in the economy.