Goldman Sachs is worried about the increasing number of Chinese companies which are taking on new debt in order to pay off old debt.
In a note to investors published July 12, Goldman analyst Hui Shan and her team published this chart (below), comparing the rise in Chinese debt as a percentage of GDP to the percentage of new debt that is taken out to purely to service older loans:
“A back-of-the- envelope calculation suggests that up to 10% of credit flows in 2015 may have been used to pay off interest on existing debt. Despite significant uncertainty, we think this issue has become increasingly important over time, rendering recent rounds of credit injections less potent in stimulating economic activity than previously.
“… companies have been devoting a rising share of income to servicing debt with the debt service ratio climbing from 12% to 20% during this period of time …”
The problem with taking new debt to pay old debt is that — like a Ponzi scheme — ultimately creditors can’t pay off their total debts. That situation occurred in the UK and US in 2007/2008, when mortgage-backed bonds collapsed, spurring a global recession.
The Financial Times published some data in May on the portion of corporate bonds Chinese companies have floated recently in order to (at least in part) pay off previous debt:
- 2014: 8%
- 2015: 44%
- 2016: YTD: 42%
Debt is a double-edged sword for China’s economic growth. As long as the economy grows faster than the debt, then companies ought to be able to pay their creditors easily. On top of that, new debt can spur economic activity the same way investment does, and the economy can grow even more. Back in 2005, roughly one unit of new Chinese debt would generate about one more unit of growth, according to research by Brandon Emmerich, general manager for North America at Wind Information, as cited in the FT.
But the opposite happens when economic growth slows, as China’s is doing now. With total debt now at 200% of GDP, and growth slowing from 7% down to 6% this year (or even lower, if you don’t believe the government’s stats), each new unit of debt delivers a lower return in economic growth. This year it takes four units of debt to create one unit of growth in China, according to Wind Information. Shan agrees: “a higher share of new credit is used for interest payments, resulting in less investment in the real economy per yuan of stimulus,” she writes.
That is having a real effect on the Chinese economy, showing up in the steel market, Shan says. “A substantial amount of money, to the tune of 36% of GDP, was created in China in 2015. Official statistics show that another $1tn of new credit was injected in the economy in 1Q2016. However, unlike the experience of 2009, we have not seen a meaningful increase in Chinese steel demand this year.”
Shan’s note links to this Bloomberg report on Chinese zombie companies — firms that owe so much debt they only continue to exist in order to take on more debt that is then used to pay off older debts. They are in the “Ponzi stage,” according to the analyst Bloomberg cites in the report:
“Some Chinese firms have entered the Ponzi stage because return on investment has come down very fast,” said Shi Lei, the Beijing-based head of fixed-income research at Ping An Securities Co., a unit of the nation’s second biggest insurance company. “As a result, leverage will be rising and zombie companies increasing.”
So — just to be clear — Goldman isn’t saying that Chinese corporate debt is currently in the Ponzi stage. It is merely suggesting you read other people’s news reports that say that. Make of that what you will.