In a week when China announced that its economy grew 6.7% year-on-year for the third quarter in succession, it’s not the steady, near-unbelievable stability in the figure that has the markets talking.
Rather, it’s one of the main factors behind that stability: China’s ballooning debt levels.
It’s a concern that simply will not go away. Indeed, as the amount of leverage within China’s economy continues to increase, the voices of concern are only getting louder.
As this chart from the National Australia Bank shows, China’s total debt level as a percentage of GDP is now comparable to even the most indebted advanced economies. (The NAB estimates that China’s debt stood at around 323% of GDP in Q2 2016, higher than other estimates as, in the bank’s opinion, they fail to capture all of China’s shadow banking sector – a major contributor to debt growth since 2012.)
And, demonstrating the rapid pace that debt loading is growing, this chart — also from the NAB — shows China’s credit-to-GDP “gap”, a ratio calculated by the Bank of International Settlements (BIS) that measures growth in private sector non-financial credit to GDP against its long-run trend.
At 30% at the end of the March quarter this year, the ratio was three times larger than the 10% threshold the BIS deems to be an early warning signal that debt accumulation levels may be unsustainable.
Last week in its semi-annual financial stability report, the Reserve Bank of Australia warned that “the interaction between high and rising debt, slower economic growth and excess capacity in some areas is raising the chance of widespread loan defaults and economic disruption” in China.
It also acknowledged that China’s “financial system has become increasingly large, opaque and interconnected”, raising “further concerns about asset quality and the funding positions of some of the fast-growing parts of the system, and increased the risk of financial contagion”.
That warning followed remarks from RBA governor, Philip Lowe, last month where he noted that “measures to address industrial overcapacity and the very high levels of debt in parts of the economy are necessary over the longer term but they are not helpful for growth in the short run”.
He described it as a “work in progress”, suggesting that we all have a strong interest in China managing this trade-off as smoothly as it can.
The prevailing theme — not only from the RBA but others — is the difficult decision facing Chinese policymakers: should they continue to focus on short-term growth, allowing leverage to build at rates far above their historic norms and risk creating financial stability in the future? Or should they bite the bullet now, allowing growth to decelerate and risk, in all likelihood, the prospect of social unrest?
Neither option seems particularly palatable, or easy, ensuring that concerns around the Chinese economy — the second largest in the world — won’t go away no matter what the GDP rate is reported as.
Investors are forward-looking by nature, and all there is at present is a whole lot of uncertainty, and debt.
Gerard Burg, senior Asia economist at the National Australia Bank, is one analyst who continues to warn about the growth in Chinese debt levels, writing in a research note released earlier today that “addressing debt concerns in coming years will be critical to avoiding a financial crisis over the medium term”.
Others fret that China will avoid making the tough decisions now, favouring instead to let the status quo remain, heightening financial stability risks in the future. But Burg believes that there is a short-term solution available to policymakers to avoid a so-called “hard economic landing” down the line.
“In the short term, Chinese authorities should seek to control, rather than reduce the debt-to-GDP ratio as severe cuts to credit necessary to produce the latter would likely lead to a sharp slowdown in economic growth,” he says.
Burg also adds that “controlling the debt issue will require increasing the efficiency of lending, particularly reducing the share of funding directed to state-owned enterprises (SOEs)”.
He suggests that while hard, reforms to these sectors will be crucial to reduce financial risks in the future:
Plans to restructure SOEs have focussed largely on mergers and partial privatisation. Allowing firms to swap debt for equity (a policy approved by China’s State Council in early October) is one way to address the debt issue, but poorly performing, highly indebted firms are unlikely to be attractive opportunities for investors – particularly those still scarred by the 2015 share market bubble burst. Similarly there are concerns that banks could be forced to swap bad loans for equity in so-called zombie firms, achieving little in terms of restructuring. Harder decisions around the weakest SOEs – including liquidation – must be considered. This would require the development of a sound and consistent bankruptcy framework understood by all market participants.
Greater competition is also a way to improve the efficiency of lending – particularly if banks are incentivised to lend to more innovative private sector firms. SOEs continue to enjoy preferential barriers to entry in a range of industries – including fast growing service sectors such as communications. Greater market access for private banks in the finance sector would likely contribute to reducing SOEs share of corporate debt – as profit rather than relationships would likely drive lending decisions.
There’s a lot of tough decisions to consider, but few will disagree with Burg that reducing the dominance of SOEs within the Chinese economy is a necessary step to reduce the risk of a damaging financial crisis in the years ahead.
Burg believes that policymakers have time to deliver these reforms, but it isn’t infinite in nature.
“While the nature of China’s financial markets provides authorities with some additional time to address the issue, urgent reform to SOEs and increased competition across the economy will be necessary to avoid a medium term financial crisis,” he says.
There’s a lot riding on these outcomes, not least the health of the global economy in the future.