China’s debt reckoning cannot be deferred indefinitely
Credit build-up will end with serious consequences for the global economy, writes George Magnus
On one of my first trips to China in the early 1990s, on the drive from Beijing airport, I remember gazing out at hundreds of workers labouring with little more than shovels on a new highway snaking its way through farmland towards the capital. By the time the Olympics came to the city in 2008, the road had been joined by a second expressway and China had grown into the world’s largest construction market. Last year, it completed the world’s second-highest building: the Shanghai Tower, 632m of luxury offices, designer shops and a high-end hotel.
But there is a bit of folklore about the topping out of skyscrapers: the builders’ ceremonial placing of the final beam often heralds the onset of grim economic news, coinciding with the end of a credit cycle that has funded a frenzy of lending for ever-bigger projects. And indeed, as the economy slows markedly, China is increasingly dependent on credit creation. The share of total credit in the economy is approaching 260 per cent and, on current trends, could surpass 300 per cent by 2020 — exceptional for a middle-income country with China’s income per head. The debt build-up must sooner or later end — and when it does it will have a significant impact on the global economy.
Back in 2008, as the western financial crisis spread, China tried to insulate itself with a big credit stimulus programme to counter factory closures and an accompanying return of millions of migrants to the countryside. By 2011 the growth rate had peaked. Its decline was led by a fall in investment in property, then manufacturing. Subsequent stimulus measures have not altered the trend for long — but one constant is a relentless build-up in the indebtedness of property companies, state enterprises and local governments.
Conventional measures of credit, however, do not fully reflect the growth of total banking assets. Local and provincial governments have been allowed to issue new bonds on yields a bit below bank loans, bought by banks — but they have not paid down more expensive earlier debts to banks as planned. Banks, moreover, have also increased their lending, often through instruments such as securitised loans, to non-banking financial intermediaries, such as insurance companies, asset managers and security trading firms. When this is taken into account, credit growth is probably running at about 25-30 per cent, or about twice as fast as official data suggest, and roughly four times the growth in money gross domestic product, the cash value of national output.
For now, China’s credit surge seems to have stabilised the economy after a sharp slowdown around the turn of the year. The property market has picked up, attracting funds from a stock market that has fallen out of favour with investors after pronounced instability in the middle of last year and early in 2016. The volume of property transactions has risen and prices have rebounded, especially in the biggest cities.
Timing the end of a credit boom is more luck than judgment. There is no question that lenders own bad loans, reckoned unofficially by some banks and credit rating agencies to amount to about 20 per cent of total assets, the equivalent of around 60 per cent of GDP. These will have to be written off or restructured, and the costs allocated to the state, banks, companies or households. Yet in a state-run banking system, where loans can be extended and there are institutional obstacles to realising bad debts, the day of reckoning can be postponed for some time.
More likely, the other side of the lenders’ balance sheets, or their liabilities, is where the limits to the credit cycle will appear sooner. Loans have to be funded by deposits, and China’s banks are venturing beyond fairly stable household deposits to more volatile funding sources in the shadow finance, interbank and corporate markets and overseas. Growing dependence on these liabilities renders the banking system, and the economy as a whole, more vulnerable to withdrawals that are prone to happen suddenly or when lenders lose confidence in economic and financial stability, as we know from 2008.
For the foreseeable future, China’s neglect of the problem of excessive debt growth looks likely to continue. Beijing cannot afford to spark a disruptive end to the credit boom and a slump in investment, with anecdotal signs of rising labour unrest and unemployment — especially before next year’s 19th party congress, where President Xi Jinping plans to consolidate his support at the upper levels of the Communist party.
The question, then, is whether the politics of debt control will shift after the congress. With a slowing economy and rising financial instability risks, it is hard to imagine Beijing making a strong commitment to cut credit dependency and impose debt management policies such as more defaults and write-offs, the sale of national assets, and the transfer of wealth from indebted state companies and local authorities to private sector households and creditors.
Yet, without such a shift, China is likely to experience greater financial turbulence than it has seen recently, which may not happen by the end of this year but will not take three years either.
The main outcome would probably be a growth hiatus of unknown duration, for which the rest of us need to be prepared.
The writer is an associate at Oxford university’s China Centre and a senior economic adviser at UBS