3.05 Escaping the Debt Trap & Implementing Fundamental Reforms
16 September 2018
To escape the debt trap, China must continue to deleverage which is one of President Xi's key supply-side reform goals launched in 2015. However, that objective has often been constrained by Beijing’s dilemma between keeping economic growth on track by encouraging investments, particularly in infrastructure developments, and pushing ahead with reforms to reduce debts which will lead to declining investments.
All the more, it is important that the Xi-Li government holds its course and push through long-delayed domestic reforms.
The Ills of Hu-Wen Government 4 Trillion Yuan Stimulus Plan
In the years after China’s accession to the WTO, China experienced exceptionally high economic growth as it attracted not only foreign capital but also production technologies and management knowhow to develop its economy. However, that growth, much of which was low value-add processing trade, came at the expense of the welfare of its workforce and the degradation of the environments. As a result, the rapid growth of the economy was accompanied by critical self-doubts and intensive soul searching.
There were vigorous debates, for example, over the efficacy of different regional development models such as the Wenzhou model (温州模式), Sunan model (苏南模式) and Zhujiang model (珠江模式). These were essentially localized economic models that had evolved according to the business, cultural, and public policy peculiarities of different regions in China. It was concluded that none of these unique Chinese local models, while successful within their regional confines, offered ready solution to help the broader China overcome its structural weaknesses and to catch up with the developed economies.
Then, in 2008, the Global Financial Crisis (GFC) struck. As the crisis spread contagiously from its epicentre in the US across to the rest of the developed economies, the Hu-Wen government sprang into action with its 4 trillion yuan stimulus plan to fireproof its economy. The massive injection of liquidity successfully averted an economic hard landing. The immediate success, however, masked the long-term structural issues of the overall economy. Suddenly, all the self-doubt the Chinese exhibited the years before dissipated and in place of the soul-searching was the euphoria arising from the belief that the development model of the West was flawed and that China’s model of state capitalism with Chinese characteristics was the right way to go.
In reality, the 4 trillion yuan stimulus exacerbated China’s structural problems. The infrastructure-focused stimulus package, which ran from 2008 to 2011, led to lavish spending on public works by local governments and created a voracious demand for steel and coal which in turn led to excessive investments in these industries. With the surge in credit and construction, China’s economy continued its ferocious expansion. In 2010, for example, when the rest of the world of mired in the Great Recession set off by the GFC, the Chinese economy expanded by 12%.
A hard landing of the Chinese economy was averted, though not only because of the stimulus plan but also because China’s strict capital control had helped to insulate it from the contagion that was spreading from the US across the rest of the tightly-knitted global financial markets. At the same time, unlike in the US where the money from the massive quantitative easing could easily leave the country in search of higher returns, China’s capital control ensured that the massive liquidity injected stayed within its border. In the end, the easy money at exceptionally low interest rates encouraged local governments to embark on infrastructure projects many with no real long term economic benefits other than to show up as GDP. SOEs and public listed companies with privileged access to credit were also motivated to borrow the maximum amount at the expense of deserving small and medium size enterprises in need of funds. In the years that followed, local governments and corporate debts shot up and the structural imbalance worsened. During the process, many “zombie” firms (i.e. perennial loss makers which are technically insolvent), which should have exited their industry, were kept on life-support by their parent companies (mostly SOEs). Based on estimates by Goldman, “the allocation of investment to less efficient SOEs has cost China about 1-2 percentage points in GDP terms.”
In effect, Hu-Wen government merely bought more time by “kicking the can down the road” and delayed their 2008 “Lehman Brothers” shock moment with the stimulus plan. By the time the demand effects of the stimulus wore off, the Xi-Li administration was laden with the problems of excessive capacity and an increasing number of “zombie” firms as well as rising indebtedness of its local governments, corporate sector and even households (because of the unrestrainable rise in property prices due to speculative demand). The excess capacity and rising debts became serious impediments to the government efforts to rebalance and restructure China’s real economy which was then struck by falling growth rate, declining industrial prices, shrinking profit margin, declining fiscal revenues, and rising systemic risks (“四降一升”: 即经济增速下降、工业品价格下降、实体企业盈利下降、财政收入下降、经济风险发生概率上升).
By delaying critical reforms and responding to changes in external demand with monetary policy activism to keep growth on track, China has fallen into a debt trap while still trying to escape the middle income trap. The task of lifting China to the ranks of high income has therefore become more daunting and complex now for the Xi-Li government with two traps to contend with at the same time.
Xi’s Efforts to Deleverage since 2015
In 2013, President Xi began tackling the problems by first launching the “One Belt One Road” initiative (also known now as “Belt and Road Initiative”) which was designed, among other objectives, to help absorb the excess capacity in China’s heavy industries.
In 2015, Xi pronounced that its government would henceforth avoid further massive stimulus to uplift growth. Instead it would embark on supply-side structural reforms (供给侧结构性改革) by cutting excess capacity, destocking, deleveraging, reducing costs and “shoring up weak areas” (“三去一降一补": 去产能、去库存、去杠杆、降成本、补短板).
In 2016, Xi began clamping down on financial risks, leverage and shadow financing by tightening rules on asset management and off-balance-sheet investment vehicles. To wean local governments and SOEs off shadow financing, Beijing began championing the use of debts. As a result of Xi’s strong actions, China saw the highest number of annual debt defaults in 2016. Efforts to deleverage continued in 2017 and the curbs on financial leverage pushed bond yields to three-year highs.
As a result of the strong clampdown on easy credit beginning, growth of fixed asset investment (FAI) by the local governments and SOEs has declined significantly since 2016. Private sector FAI growth has also slowed in recent years because of diminishing return. In 2016, for example, private investments grew just 3.2%, the weakest on record. The drag caused overall fixed-asset investment to rise only 8.1%, the lowest growth rate since 1999, despite an 18.7% increase in investment by state entities. As a result, even with higher government spending and record bank lending, China’s economy grew the slowest in 26 years at a rate of 6.7%, down from 6.9% in 2015. In 2017, growth of FAI continued to slow to 7.2% though GDP grew marginally to 6.9%. Overall, growth of FAI has been on a downward trend after peaking in 2009 (see graph).
Rising Default in 2018 but No Systemic Risk
The FAI continued its downward trend in 2018 with growth slowing to 6% during the first six month and 5.5% in July. GDP growth slowed correspondingly to 6.8% during the first half of the year. However, a rapidly slowing economy amid a worsening trade war have drastically changed China’s economic outlook.
In July 2018, key data released by China’s National Bureau of Statistics (NBS) have all missed expectations. Annual retail sales growth, for example, rose by 8.8% — down from 9% in the previous month and missing expectations of a 9.1% rise. Industrial output, on the other hand, rose by 6% against an earlier forecast of 6.3%. Urban FAI climbed by 5.5% over the period from January to July, against expected growth of 6%. All these key data, even before US tariffs are making an impact, are pointing to an acceleration of an economic slowdown in the second half.
Already, the slowing economy has caused more firms to default. In the first seven months of 2018, there were at least 20 defaults, almost as many as in all of 2017. More defaults are likely to follow as 2018 marks one of the busiest redemption periods for yuan and offshore debt since the Lehman Brothers’ collapse. From August to end of the year, companies face $365 billion of bond payments. For Chinese firms whose debts are denominated in dollars, the already difficult situation is exacerbated by a depreciating RMB which has lost 5.2% of its value against the dollar this year. The weaker RMB means that these borrowers need to use more yuan to pay offshore dollar debts thus increasing the risk of defaults. Moreover, there is every likelihood that Trump may make good his threat to impose tariffs on all US imports of Chinese products. In short, the worst is yet to come.
To be sure, though, the debts do not constitute a systemic risk. Its overall level, despite rising to 261% of GDP in 2017 from 252% in 2015, is not high by international standards. Moreover, China still enjoys a healthy current account surplus and has been a net creditor to the rest of the world for decades. It is also sitting on more than $3 trillion of foreign-exchange reserves. China therefore has the wherewithal to tackle its debt problem. In addition, the balance sheets of the Chinese state-owned banks, the government and the People’s Bank of China are all interconnected and the risk is largely contained in the broad state sector.
Finally, the government has worked hard over the past few years to diffuse the debts’ systemic risks to the Chinese banking system by clamping down on shadow financing; allowing non-banking financial institutions to assume some of the risks; and opening up domestic debt markets to foreign investors. According to a report by JPMorgan, foreigners bought US$13.5 billion of onshore bonds in June, bringing non-resident purchases in the first-half of this year to nearly US$60 billion, compared with US$52 billion for the whole of 2017.
So, even though the debts impede the government’s efforts to restructure and rebalance the economy and also severely restrict China’s fiscal response to the worsening economic slowdown arising from the trade war with the US, as a whole, the situation is under control and a meltdown looks unlikely.
Rising Default Not an Entirely Bad Thing, Shows Supply-side Reforms Working
Given that the systemic risk to the financial system and capital markets is contained, the rising default may not be a bad thing for China. The Chinese policymakers must have anticipated that when they embarked on their supply-side reforms and their quest to deleverage. It is an indication that their efforts to reform and deleverage are working. How can the supply side be reformed if inefficient companies are not allowed to fail?
Hence, allowing the defaults to take place will send a very important signal to both the lenders and borrowers that market forces are at work so that lenders ought to pay attention to credit risk while borrowers, including the SOEs, know that they are responsible for their own debts. Over the longer term, the Chinese economy will become more productive and efficient as the inefficient ones are allowed to exit the market before they become zombies. Rising default therefore also serves as an important means to let the market reform the state sector. In short, rising defaults is a good thing for China. Ideally, the government should not interfere particularly when SOEs are involved.
The problem, however, is that intervening authority is usually the local governments because allowing SOEs, or for that matter, even public listed private companies under their charge to fail not only makes them look bad but also will have adverse ripple impacts on their local economy.
As for the central government, given the uncertainty created by the trade war, they may be tempted to intervene for fear that a spike in headline-grabbing dollar debt defaults may spook the market and create a domino effect, sparking off capital outflow and a possible attack on the RMB. The last thing the Chinese need now is a currency crisis to complicate the already complex situation.
In the end, whether or not the central government will step in to intervene or stop the local governments from intervening, will depend on how confident they are in containing the risks, especially if and when the trade war worsens.
China’s Catch-22 Situation: Continue to Deleverage or Loosen the Reins?
The rising default is only the symptom. The underlying problem is the economic slowdown sparked off by the government’s crackdown on infrastructure investment, which has been growing by only 5.3% in the first eight months of 2018, down from 18.5% in 2017.
As for GDP growth, the Central government figures gave a national inflation-adjusted growth rate of 6.8% for the first half of the year, compared with 6.9% in the same period last year. The figures from difference provinces, however, point to a more alarming picture of a broad slowdown, with some parts of the country stagnating or even contracting. Of the 29 provinces, only 15 fared better than the national average, compared with 21 during the same period last year. The number of provinces below the national average rose from seven to 12 during the period. Jilin, a rust belt province bordering North Korea, reported only a 2.5% rise in headline growth in the first half, the lowest of all reporting jurisdictions. Other areas that recorded growth rates of below 6 per cent include Inner Mongolia, Tianjin, the northeastern provinces of Heilongjiang and Liaoning, the northwestern province of Qinhai and even Hainan, the southern island that has become a centrepiece of China’s efforts to open up its economy.
Notably, the data does not reflect the impact of the trade war which began to take effect only in the second half of the year. Hence, the slowdown is expected to accelerate in the months ahead.
The Chinese government is thus once again caught in the Catch-22 situation of having to decide whether to continue to crack down on easy credit and shadow financing to fight the massive debt bubble or to loosen the reins in order to keep the economy growing at about 6.5%.
Looking back over the past decade, China has had no economic recovery that wasn’t preceded by infrastructure stimulus. With economic data trending down, some analysts are already predicting that, to stop the bleeding, the Chinese government may return to some old habits of boosting growth with infrastructure stimulus. This time round, though, the government seeks also to preempt excessive borrowing by the local governments. One way to achieve that is by reviving public private partnerships (PPP) in which private firms co-invest with local governments to build and operate public facilities. PPP started to take off in 2014 when Beijing sought to control off-budget borrowing by local governments. Some municipalities used them as a tool to hide liabilities. For instance, the private partner could be promised a fixed return at regular intervals from government land sales, and a guaranteed equity buyback. Moreover, more than 60% of the “private” partners in PPP projects are SOEs. Hence, the projects often drew little in the way of private money. As a result, Beijing had been cracking down on these partnerships. Since November 2017, about 12% amounting to 2.4 trillion yuan ($363 billion) have been shelved. As of end of June 2018, debt associated with PPP projects constituted about 14% of local government borrowings, according to estimates by the Bank of America Merrill Lynch. The actual proportion is probably higher, with much debt held on the balance sheets of the government’s partners.
Besides trying to revive PPP, policymakers have recently also implemented a slew of measures to combat the slowdown. In late June, PBOC cut reserve requirement ratio (RRR) to free up 700 billion yuan ($106 billion) of which 500 billion would go to large banks to finance debt-for-equity swaps aimed at cutting debt at large state-owned enterprises and the remaining 200 billion should be used for financing SMEs. In July, China’s State Council decided to adopt a “more proactive fiscal policy” and to speed up raising and spending 1.35 trillion yuan for local government infrastructure projects. Other measures include tax cuts and injection of liquidity into the banking system by the PBOC to the tune of $75 billion to spark business activity.
It is quite clear that the central government is trying to prevent the return to shadow financing in fighting the current slow down but there is no telling whether it can hold the course if the situation worsens. Again, a lot depends on how the trade war with the US will evolve in the months ahead and how long it will last. Already in August, the Politburo has announced that it will shift focus back to growth after acknowledging that the trade war with the US has brought “new challenges”. Still, the government has taken the pain to reiterate that the recent measures neither imply that the deleveraging campaign is ending  nor indicate the return of another blanket stimulus plan similar to the 2008 4 trillion yuan rescue package.
Ideally, any efforts to stimulate growth this time round will likely to be more targeted to benefit SMEs or high value-add industries critical to the realization of Xi’s “Made in China 2025” (MIC2025) initiative. The RRR cut, for example, is targeted for ‘debt-to-equity swap’ and ‘supporting SMEs’. As for support of high value-add industries, the figures for first half of 2018 indeed already indicate what could be the beginning of an emerging trend. Despite lower growth in overall investment activities, FAI in high-tech manufacturing displayed strong momentum by growing 13.1% year-on-year, outpacing the country's general FAI growth of 6% by 7.1 percentage points.
Trade War or No Trade War, Tough Reforms Still Needed to Escape the Debt Trap
Whatever short term response measures adopted hereon, they do not absolve the government from carrying out long-overdue fundamental reforms, not the least because efforts over the past decade since the GFC have shown that government’s measures to boost growth not only failed to achieve their objectives but in reality worsened structural imbalances which rendered further measures increasingly ineffective. To support growth, for example, the Chinese government had embarked on monetary easing in 2008, 2011, and 2014. The positive effects on the real economy weakened with each round as evidenced by the downward trend of the GDP growth rate from 9.7% in 2008 to 9.5% in 2011, 7.3% in 2014, and 6.9% in 2017. In the end, all that was achieved was the progressive rise in total debt-to-GDP ratio from 129% to 166%, 204%, and 241% respectively.
One of the oft-criticized Chinese government policies contributing to the brewing debt crisis, for example, is the practice of declaring annually a pre-determined growth rate to achieve. In 2010, the Chinese government also pledged to double the size of the economy by 2020. As a result, the Chinese government has to sanction run-up in debts by local governments in order to meet its annual growth rate and its 2020 GDP target. IMF noted that had the Chinese government not turned on the credit taps, average real GDP growth in the five years to 2016 would have averaged 5.3% rather than 7.3%. Another estimate asserts that China’s growth would fall from 6.5% to a trend rate of 3.4% if it were to stop using debts to manufacture “growth”.
Other measures of long term reform include reducing dependence on the state sector to spur economic activities; reforming the capital market to ensure more equitable distribution of funds; reforming the fiscal and tax system to reduce local governments’ needs to incur excessive debts; reforming the cadres’ performance evaluation system to reduce the incentives for local governments to grow at all costs and to hold them accountable for all debts; and continuing the efforts to rebalance the economy so that the services industries and consumption can play a bigger role in driving GDP growth.
These ideas are by now common wisdom. The fact that they remain mere ideas shows how difficult reforming Chinese economy is because of deeply entrenched vested interests. This is why Xi amassing so much political power may not be a bad thing for China, at least for pushing ahead painful reforms. With his unassailable political position, Xi is much better able than his predecessors Hu Jintao and Jiang Zeming to take on the institutionalized vested interests. Xi has already begun to do so with his anti-corruption drive which enables him to replace corrupt top executives of SOEs with people he trusts. But in the end, it still boils down to what his priorities are: whether his main objective is to merely fortify his political control and extend his rule to become leader for life or to use it to implement fundamental changes within the state sector which still control large swaths of the economy even though it is the non-state that accounts for more than 80% of employment and 50% of tax revenues.
China is at a make or break juncture of its economic development. Its corporate, local government and household sectors are all in debt to the brim. Its firms in the private sector have been and are still seriously marginalized in a domestic environment designed to support the inefficient state sector. As a result, SOEs are able to enjoyed extraordinary profits without having to innovate and to compete. The end result is that both private firms and SOEs may become uncompetitive internationally once they lose their low-cost advantage as a result of rising wages and costs at home. Meanwhile, the excess capacity created by the past efforts to support growth results in falling margin which further hamper firms’ ability to invest for the future.
The Xi government thus have a mammoth task ahead even without the Sino-US trade war. The trade war did not create China’s problems of structural imbalances and mounting debts. The Chinese economy was already slowing even before the start of the trade war. With or without the trade war, China needs to reform to become more competitive as it moves up the value-add ladder to escape the middle-income trap. Taken positively, the trade war actually helps to accentuate China’s structural problems and provides Xi with an opportunity to rally his people behind him to push through his supply-side reforms.
In the end, what Xi and his team decides to do over the next few years will decide whether China will realize its dream of becoming an economically powerful developed nation, as envisioned by his “Made in China 2025” initiative, or will remain stuck within not only the middle-income trap but also the over-sized debt trap, for a long time to come. It will be a great pity if Xi, after having amassed so much personal power and authority, chooses not to put that power to good use and instead squanders that opportunity by again falling back on the “proven” approach of boosting demand through fiscal and monetary stimulus.
One thing is for sure though. Given that Xi is likely to stay on as the head of the state for the foreseeable future, “kicking the can down the road” to leave the problems to his successor is no more an option. Moreover, there is a price that Xi pays for making himself chairman of everything: the Chinese people has higher expectations from his leadership and he has no one else to push the blame to. In the end, this crisis will be a true test of Xi’s leadership. Proving his mettle will help to quieten the criticisms levelled against him from various quarters for changing the constitution to extend his rule.
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 See Matthew C. Klein. (2015). “Digging into China’s debts.” FT. 2 February, 2015.
 See Bloomberg. (2018). “China may ‘slowly ease efforts to curb debt this year’.” 5 April, 2018
 Reuters. (2017). “China ‘to keep 3 per cent budget deficit in 2017 as debt risks grow’.” 26 January, 2017.
 See Sam Jacobs. (2018). “There were more disappointments in China's latest round of economic data.” Business Insiders. 14 August, 2018.
 See Nicholas Spiro. (2018). “China’s monetary easing supercharges its bond market but leaves harder questions about its economy unanswered.” SCMP. 14 August, 2018.
 See Sidney Leng. (2018). “China’s economy worse than it seems - even before trade war bites.” SCMP. 31 July, 2018.
 See Linette Lopez. (2018). “China is once again staring down the biggest Catch-22 in its economy.” Business Insiders. 1 September, 2018.
 See Ren Shuli. (2018). “Grab a Shovel, China’s Ready to Build Again.” Bloomberg. 26 August, 2018.
 See Gabriel Wildau. (2018). “China’s economy faces deeper risks than trade war.” FT. 28 June, 2018.
 See Sidney Leng. (2018). “China’s economy worse than it seems - even before trade war bites.” SCMP. 31 July, 2018.
 See Tetsushi Takahashit. (2018). “China's Politburo shifts focus back to growth.” Nikkei Asian Review. 1 August, 2018.
 See Bloomberg. (2018). “China may ‘slowly ease efforts to curb debt this year’.” 5 April, 2018
 See ChinaDaily. (2018). “China's fixed-asset investment up 6% in H1.” 16 July, 2018.
 See Tom Mitchell. (2017). “IMF warns China over ‘dangerous’ levels of debt.” FT. 15 August, 2017.
 See Tim Morgans. (2017). “What is Really Happening with the Chinese Economy?” Surplus Energy Economics. 11 March, 2017.