The markets have worried about China’s debt load for some time but are they right to do so?
The Case for the Prosecution. Last month, the BIS, the central bankers’ bank, updated its four early warning indicators of banking crises: two were flashing red and another amber. The BIS is especially keen on the “credit gap” – the percentage spread between actual and trend credit-to-GDP – as a crisis leading indicator. It reckons that a reading over 10% is a cause for concern: China’s gap was 30.1% in March.
There is no doubt that China’s private sector debt has risen rapidly. The credit-to-GDP ratio has increased by roughly 60 percentage points over the past five years. An IMF study found that, in 38 out of 43 global instances where the ratio grew by more than 30 percentage points, the result was a financial crisis, much slower growth or both.
The argument is that excessive credit growth reduces the efficiency of capital spending and hurts corporate profits and asset quality. This in turn prompts an increase in defaults and non-performing loans.
The Defence. However, all may not be lost. First, China is engaging in massive economic and social change, one consequence of which is slower growth. Thus, the IMF’s narrative is correct but may not mean a financial crisis is due.
Second, China’s overall debt burden (including government debt) was 255% of GDP in March which was below that of five of the G7 – Canada, France, Italy, Japan and the UK. In other words, the debt ratio is nothing unusual, although it is high by emerging markets standards.
Third, since China’s public debt ratio is modest, the government has room to act in the event of a corporate debt crisis, taking private sector bad debts onto the public balance sheet, much as the advanced nations did in 2008-09.
Fourth, there is a problem of definition. Much of the increase in debt belongs to state-owned enterprises (SOEs), which might be better classified as local government debt. Thus, one would not expect the usual dynamics outlined above to apply. This does not deny that many SOEs are in trouble – there have been at least five major SOE near-defaults since 2014 – but the analysis should be different.
Five, the government has already recognised the problem and taken action. It has reduced coal and steel capacity, identified and tackled “zombie” companies, announced SOE reforms, improved local government finances and encouraged debt-for-equity swaps.
And, six, China has been here before. In 1997 about a quarter of SOE loans were non-performing. This prompted the government to step in with a rescue plan worth over 30% of GDP over the next decade.
The Verdict. China’s debt mountain is clearly a problem. But there are good reasons to think the position as not as bad as some analysts make out. Investors should keep this on the risk register and monitor closely. Meanwhile, the chances of a Chinese recession are slim and Asia-Pacific ex-Japan remains one of our favoured equity regions.
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