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3.01 China’s Burgeoning National Debt amid a Global Debt Trap
16 September 2018
Global Financial Crisis and the Rise of Global Debts
Over the past decades, global debt has been growing among corporate borrowers, governments, households and financial institutions.
Professor Charles Goodhart at the London School of Economics attributes the swelling debts to three factors since 1970s: the increase in global savings relative to investment, the willingness of the financial sector to lend, and the demand for safe assets. According to him, favourable demographics in the past 40 years have created a global savings glut causing real interest rates to fall. A substantial portion of these savings, belonging to emerging economies, were parked as official reserves in advanced countries where the banks’ then extended credit at lower interest rates. The cheap money encouraged consumption and speculative activity rather than investments in long-term productive projects. In the end, the speculations created inflated asset bubbles which eventually evolved into crisis which prompted governments to inject even more liquidity into the system by creating more debts.
Take the last Global Financial Crisis (GFC) of 2008-2009, for instance. Global debt rose to more than $200 trillion, or $27,000 for each person in the world when governments around the world implemented measures to address the liquidity crunch in the immediate aftermath of the crisis. In the years that followed, in their haste to prevent a downward spiral of real economy due to credit crunch, central bankers flooded the markets with even more short-term liquidity through quantitative easing and negative interest rates. The flood of cheap liquidity caused debts around the world to spike. By 2015, global debt of households, non-financial corporates and the government – so called non-financial debt – had risen to 233% of GDP from 212% prior to the GFC. By the end of 2017, worldwide debt had reached a record $237 trillion, according to the Institute of International Finance (IIF).
The monetary measures prevented the crisis from worsening but they also helped politicians to put off structural reforms. Instead of finding ways to bring down the level of debts, governments, banks and companies rolled over old debts by creating more new debts. The result was slower growth from declining productivity, even as borrowing continued for companies and governments which had become addicted to easy borrowing rather than adopting tough reforms. In short, the world has sunken into a debt trap.
Economic Risks Associated with Emerging Market Economies’ High Corporate Debts
Notably, even though most of the debts are in advanced economies, most of the increase in the debt ratio took place among the emerging market economies (EMEs). In the advanced economies where the increase is more modest, the build-up has been mostly driven by government debt. In the case of the EMEs, the non-financial corporates, particularly in the mining, energy, construction (materials) and real estate sectors, were mainly responsible for the new debts. Since 2008, their total borrowings have risen by a staggering $15 trillion, surpassing $24 trillion by the third quarter of 2015. The average debt-to-GDP ratio widened by 40 percentage points to over 100%, which is significantly higher than the average ratio of 86% for advanced economies. Among the EMEs with higher debts, Greater China (i.e. including Hong Kong) stands out. In fact, most of the increase in EMEs non-financial corporate debt can be attributed to China. Excluding Greater China, the increase is more modest at 12% of GDP, to some 53%. In other words, the EMEs’ corporate debt ratio is skewed by China.
Borrowing on the current scale by EMEs’ corporate sector is risky because a downturn in corporate revenues can easily impair borrowing firms’ ability to repay. Moreover, firms in EMEs are often forced to borrow offshore due to underdevelopment of their domestic capital markets. Such debts, usually denominated in foreign currencies (mostly US dollar) carry an extra currency mismatch risk. Theoretically, the risk can be mitigated by firms hedging the foreign currency risks at the point of assuming the debts but most firms do not practice hedging in reality. A case in point is the 1997 Asian Financial Crisis (AFC). Before the crisis, many Thailand firms were borrowing dollar debts heavily betting that Thai Baht would continue to appreciate making it easier to service the debt later. But when the country’s current account deteriorated and Baht came under attack. The Thai government defended Baht selling their reserves of foreign currencies (mostly US dollar) to buy Baht. When the foreign exchange reserves was depleted, the Thai government had no choice but to devalue its currency. Many firms soon developed difficulty as they now need more Baht to repay their dollar debts. Meanwhile, the market panic spreads through contagion and the currency of other economies within the region also came under attack by speculators. What started off as a Thai crisis soon evolved into the AFC.
Today, the excessive debts by the EMEs have created the conditions for the making of another AFC-styled financial crisis. The situation is exacerbated by some governments’ mismanagement of their economy causing their currency to become overvalued. Moreover, as monetary policy normalizes among advanced economies, funding conditions for emerging market companies can worsen significantly making it increasingly difficult for them to roll over existing debt or raise new debts. This, along with the current Sino-US tariffs war and the threat of slowing world trade, could disrupt global momentum as business confidence and investment plunge.
The Bank of International Settlements (BIS), in particular, views China as among those most vulnerable to a banking crisis today because of the size of China’s debt and the speed of its debt expansion.
Evolution of China’s Domestic Debts Since its Opening Up
Briefly, China’s history of national debt has gone through the following phases:
Debt increase lower than GDP growth (1980s – 2004) : Deng’s economic reforms began first with the rural agricultural sector. As agricultural yield and household income rose, farmers began to diversify their activities. Some started their own small private business while others formed collective enterprises known as Township and Village Enterprises (TVEs) with the support of local government. By the 1980s, SOEs began to face rising competition from these TVEs and small private firms which were many efficient. Many SOEs became unprofitable but were kept on life support by the state banks because the SOEs played important social functions of providing jobs and welfare. By the 1990s, the state banks were plagued by problem of non-performing loans made to the SOEs. The problem, however, was kept under lid by the rapidly expanding economy and by the fact that the lenders were state banks. To tackle the bad debts, Premier Zhu Rongji first embarked on SOEs reforms through his zhuada fangxiao (抓大放小 Holding on to the big SOEs, letting go of the small) initiative to ‘stop the bleeding’. At the same time, asset management companies were set up to take over the non-performing bank loans. After the banks were cleaned up and recapitalized, foreign investors were invited to hold a stake in the state banks to improve on the management of the banks. Notably, much of the debts raised during this phase was invested in the manufacturing sector and in basic infrastructures which over time contributed to the impressive and robust double-digit GDP growth.
Debt and GDP growth were basically synchronized (2004 – 2008) : In this period, GDP growth was at a stable and similar pace as the debt increase, which shows that debt had its positive function on economic activities. Industrial capacity expanded rapidly also as a result of an influx of FDI. As a result of rapid pace of industrial investments by debts and by foreign capital inflows, Chinese economy expanded quickly and China became the “factory of the world”. Much of the growth, however, was still low value-add. In an attempt to move up the value-add ladder, the Hu-Wen government began efforts in 2006 to restructure the economy.
Debt increase higher than economic growth (2008 – 2015) : Chinese government implemented the 4 trillion yuan stimulus in the aftermath of the GFC. 60% of the plan stimulus was in the form of bank loans which were dispensed mostly to the SOEs and local governments. Private sectors firms, particularly the SMEs, were deprived of loans to expand because the state banks preferred to lend to SOEs and local governments which were seen as safer borrowers backed by implicit state guarantees. Many SMEs turned to underground banking paying exorbitant interest rates. Local governments also began amassing borrowings through financing vehicles while banks practiced off-balance sheet shadow banking. Both SOEs and local government exploited their privileged access to cheap capital and maximized their borrowing. Debt exploded during this phase. According to Goldman Sachs, China’s debt buildup since the GFC has been one of the largest in modern history. To prevent hard-landing of the economy, critical reforms that could have helped to restructure the economy were delayed by the Hu-Wen government. Economy began to slow because of excess capacity and the sluggish external economy. Returns from industrial investments began to shrink. When the excess liquidity was diverted into more lucrative speculative property investments, housing prices spiked. Household sector borrowings also began to hike because of rising mortgage loans. Consumer financing also surged with the proliferation of non-bank financial institutions brought about by the deregulation of the market in 2014. Overall, there were wasteful resource allocation and increasing financial fragility. Investment in this period is more on infrastructure than manufacturing.
In 2015, Xi launched his supply-side reforms and began developing the domestic debt market to reduce the systemic risks caused by overdependence on the banking sector. In 2016, the government began to clamp down on shadow banking and to rein in excessive borrowing by SOEs and local governments. Despite its government’s strong deleveraging efforts, however, China’s debt continues to build up. By the end of 2017, the Chinese total debt-to-GDP rose to an estimated of 317% (or 282% if financial sector debts are excluded, compared with 158% at the end of 2008). As for speed of its debt expansion, while its nominal GDP expanded 11.2% in 2017, credit grew by a faster 13.5%, although down from the 18.0% during 2016. In other words, even though debt growth had slowed in 2017, the rate was still faster than that of nominal economic growth.
Hence, up till 2015, China's domestic debt is predominantly lending from domestic banks to especially the state sector comprising SOEs and local governments. After 2015, however, the Xi-Li government has begun to progressively shift borrowings from banks to domestic debt market.
Rise of China's External Debt
To be sure, until the late 1970s, China had almost no external debt because of Mao’s autarkic policy of “self-reliance”. Restrictions on external borrowing were very tight. China’s experience with external debt really began to accumulate only after its opening up to the world under the leadership of Deng Xiaoping in 1979 when China needed financing for machinery and materials for the development of its economy.
After 2014, Another trend that emerged particularly after 2014 is the rapid rise of China’s foreign debt. As can be seen from the graph, China's foreign debts spiked after 2014 as the Chinese government launched its supply-side reforms and the deleveraging efforts.
The surge in China's Foreign Debt
Extracted from : Bloomberg.
In less than 4 years from end of 2014 to September 2018, foreign debts more than doubled from $895 billion to $1.9 trillion. For a $13 trillion economy, some may say that is not a major amount. But focusing on the headline number significantly understates the underlying risks. For example, because short-term debt accounted for 62% of the total as of September 2018, $1.2 trillion of the total foreign debt will have to be rolled over in 2019. Just as worrying is the speed of increase: Total external debt has increased 14% in the past year and 35% since the beginning of 2017.
Today, external debt is no longer a trivial slice of China’s foreign-exchange reserves which have been falling since they peaked of $4 trillion in June 2014. As of end of November 2018, China's foreign reserves stood at just over $3 trillion. The combined effect of rising foreign debt and falling reserves means that as a percentage of foreign reserves, short-term foreign debt has increased from 26% in March 2016 to 39% in September 2018.
The Fall in China's Foreign Reserves
Extracted from : Bloomberg.
Moreover, in a Daiwa Capital Markets August 2018 report, China external debt was estimated to be between $3 trillion and $3.5 trillion. In other words, China’s external debt may be grossly understated by as much as $1.5 trillion after accounting for borrowing in financial centres such as Hong Kong, New York and the Caribbean islands that isn’t included in the official tally.
Chinese companies also rushed to borrow in dollars when there was a 3% to 5% spread between Chinese and US interest rates and when the yuan was relatively weak and was expected to strengthen. Borrowers would thus benefit from not only lower borrowing costs but also an additional bonus from likely currency gains. Now, with the spread shrinking and the yuan depreciating for most of 2018, refinancing debt in dollars has become harder and more risky. This is especially so as the US Federal Reserve has begun to raise rates and reduce its balance sheet.
Furthermore, Xi’s Belt and Road Initiative may have also exacerbated the buildup of China’s foreign debt. To promote the Initiative, Chinese companies has been borrowing dollars on international markets and lending around the world for everything from Kenyan railways to Pakistani business parks.
Looking ahead, with repayments of the dollars peaking in 2019 and 2020, China will likely face mounting dollar funding pressure as Chinese firms either draw from the central bank’s foreign-exchange reserves (a prospect Beijing is unlikely to allow) or buy dollars on international markets to repay their dollar debts. However, there are only 617 billion yuan ($90 billion) of offshore renminbi deposits in Hong Kong available to buy dollars. This means China could see a significant outflow of RMB which would cause its value against the dollar to fall.
Is a Chinese Financial Collapse or an Economic Hard Landing Imminent?
As always, the trajectory of the fast increase of both domestic and external debts in China has once again brought forth doomsayers’ predications of imminent Chinese financial collapse, economic hard landing or China's Minsky Moment. Notably, none of those past postulations about China’s collapse came true. Each time, the Chinese economy not just “muddled through” but scaled new height to become the world’s second largest economy in nominal terms by 2009, the world’s largest exporter by 2010 and the largest trading nation by 2013.
[What is a Minsky Moment?] A Minsky moment is a sudden major collapse of asset values which is part of the credit cycle or business cycle. Such moments occur because long periods of prosperity and increasing value of investments lead to increasing speculation using borrowed money.
To be sure, the challenges China faces today are a lot more complex because reforms meant to fix problems had been deferred by the outbreak of the GFC. Besides the issue of massive debts and rising defaults, the Chinese government now also has to contend with problems of excess capacity, housing bubble, widening income and wealth inequality, a powerful but inefficient state sector, an improving but still repressive capital market largely geared towards supporting the state sector, a middle-income trap, and now the worsening trade war with the US.
On the positive side, however, China is today a lot more prepared in handling its economy. Institutionally, despite the continued presence of a strong visible hand, its “market orientation with state guidance” approach has been largely successful in mobilizing national resources and moving the economy, including the private sector, in a unified manner towards a distinctly defined state objective. Over the years, China has also implemented reform measures to improve the width and depth of its financial market and to gradually open it up to allow for foreign participation. In addition, China has also begun the process of internationalizing its RMB by putting in place a worldwide network of authorized clearing centres backed by its own cross-border renminbi payments system, the China International Payments System (CIPS). Financially, China not only still had a sizable foreign exchange reserves in excess of $3 trillion but also continues to enjoy a healthy trade surplus and strong inflow of foreign direct investments. Having gone through the Asian Financial Crisis and the Global Financial Crisis with China emerging relatively unscathed, Chinese policymakers and regulators are a lot more experienced and confident in tackling any crisis. Hence, China has not only the financial resources but also the experience and expertise to defend RMB in the event of any capital flight. More importantly, China is still enjoying decent economic growth. Even in an event of all-out Sino-US trade war, China will be able to temporarily revert to using infrastructural developments to prevent an economic hard landing and to buy time so that it can seek alternative markets for its exports and to continue to restructure and rebalance its economy by investing aggressively not in blindly expanding industrial capacity but in developing competing technologies needed for realizing Xi’s ‘Made in China 2025’ vision. It’s not ideal for the Xi government and it may take longer to “make China great again” but China is unlikely to alter its long term course of development aimed to lift its people out of the middle-income trap.
Still, China’s ability to withstand economic shocks does not preclude the need for critical reforms. Its economy is now at an important cross road now. Without those reforms, even if it succeeds in muddling through the debt problem and the trade war without triggering a crisis, it would merely be setting the stage for an even bigger one down the road.
NEXT: 3.02 China's Corporate Debts
 See Atradius. (2016). “A closer look at corporate debt in EMEs.” 5 May 2016.
 See Andrew Sheng. (2016). “How to get out of the debt trap – without printing more money.” SCMP. 27 May, 2016.
 See Atradius. (2016). “A closer look at corporate debt in EMEs.” 5 May 2016.
 See Li Yuefen. (2017). “China’s Debt Problem And Rising Systemic Risks: Impact Of The Global Financial Crisis And Structural Problems.” South Centre. Research Paper 83. November 2017.
 See Dan McCrum. (2018). “Over in China, a debt boom mapped.” FT. 5 February, 2018.
 See Dan McCrum. (2018). “Over in China, a debt boom mapped.” FT. 5 February, 2018.