Does China have a Debt Problem?

For many years concerns have been raised that imbalances in China’s financial system are a threat to economic stability.

Way back in 2007, Premier Wen Jiabao, asserted  that China’s economy was  “unstable, unbalanced, uncoordinated and unsustainable”. This idea was reiterated by a People’s Bank of China report this week that warned of an “arduous task to prevent and defuse financial risks.”

The sentiment is echoed by prominent U.S. hedge funds that for years have bet that the financial system’s fragility would cause a collapse of the yuan. Prominent China bear, Kyle Bass of Hayman Capital Management, recently repeated his case to CNBC, saying “China is running the largest financial experiment the world has ever seen. And the economic tides have turned negative for them.” Hedge Fund, Crescat Capital, echoed this sentiment last week, opining that”the Chinese banking asset bubble is currently the largest of any country ever with 400% on-balance-sheet banking asset growth relative to GDP in the last decade to $40 trillion.”

At the center of the concerns lies an unprecedented accumulation of total debt.  The chart below from the Bank for International Settlements (BIS) shows that China’s debt as a % of GDP  has more than doubled over the past decade. This is a high level of debt for a developing country like China, putting it at a level in line with many advanced economies. The concern is that the economy has become over-reliant on credit, of which much is mis-allocated to low-return activities. The risk is that at one point the debt could become an impediment to growth, leading to a “Japanification” of the economy, characterized by over-leveraged “zombie” companies.

Much of the criticism revolves around the nature of the Chinese financial system, which, in the tradition of the East-Asia developmental model, is much more driven by official policy goals than by the profit motive. In China the banks are seen as the instrument to channel household savings to the government’s priority activities.

Like Japan, the Chinese financial system is fully anchored in domestic savings, and, therefore not vulnerable to the mood-swings of foreign investors.

But, the Chinese may have additional advantages over Japan. Regulators are powerful and highly credible and have enormous flexibility to fix problems.  Their power and effectiveness is enhanced by the reality that the banks are owned by the state and can  rely on the government for capital injections. This means that bank liabilities – mainly loans to state entities – can be restructured at will.

Also, Beijing has the advantage of being exceptionally asset rich, because of the Communist legacy of state-ownership of productive assets.  The following chart from a recent IMF report, illustrates this clearly. Imagine if the United States government owned 80% of corporate America; concerns over the U.S. national debt would probably not exist. In any case, the Chinese authorities are well aware of market concerns with the high-rate of debt-accumulation and they are trying to manage them. Since the huge stimulus implemented during 2009-10 in the wake of the global financial crisis, China has consistently slowed down credit growth, as shown below in the chart from Goldman Sachs. Monetary authorities have sought to gradually slow credit growth, while at the same time using temporary stimulus to smoothen business cycles.  The following chart, from Macro-ops, shows how monetary authorities have eased on two occasions since 2010 but then returned to the credit- tightening trend. In late-2018, the PBOC initiated a third easing phase which continues to today. In addition to sharply reducing the rate of credit growth, the government has also redirected lending to households. As the BIS data shows in the first chart above, about half of credit growth has been funneled to households, mainly for mortgages. Since 2011, credit to households has risen from nearly zero to 58% of GDP. Credit for residential construction also makes up a large part of new loans. Adding these two items together, we see that a significant part of credit expansion has gone to support residential housing. The chart below shows the strong ties between Total Socal Lending — the Chinese term for total lending — and construction activity. In essence, since the great stimulus period after the GFC the Chinese financial system has become increasingly tied to residential real estate.  This is a natural development of the government’s efforts to transition the economy from dependence on infrastructure and exports to one that is driven by household consumption. While in the past  the  very high savings of the population had been channeled to state companies for nation-building investments, increasingly they are going to households in the form of mortgages and personal loans.

This is not exceptional by international standards. The quirk in the Chinese system, is that residential real estate also serves as a primary destination for long-term investments. This is also the case in many developing countries like Brazil and Turkey, where savers see residential investments as a safe harbor for long-term savings, but it may be going to extremes in China. We see this in reports of 65 million empty apartments.

The enormous amount of savings that the Chinese have in real estate means that the government is very concerned with maintaining consistent appreciation for housing and is careful to manage supply and demand for through financial measures. This can be seen in the chart below from Gavekal, which shows clearly how the monetary policy cycle is adjusted according to the trend of residential real estate prices, the objective being to engineer steady appreciation. It appears that, to a considerable degree, Chinese monetary policy is now aimed at guaranteeing stable returns for China’s owners of real estate. The current dilemma for monetary authorities is that, though the economy needs stimulus, the real estate market does not. In general, housing prices are relatively high at this time and are in no need of stimulus, as we see in the following chart.

However, the Chinese monetary authorities have many tools available. Given the current need for stimulus, the authorities are clearly rechanneling lending to SOE’s for recently announced large infrastructure investments. This means we are likely to see a temporary boost in total lending growth, with a focus on economic stimulus through traditional fixed asset investments, as the authorities try to steer through the current economic malaise.  

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