Consider the negative consequences of China’s growing debt
For the movie star Zhao Wei and her husband, the business magnate Huang You Long, it was not a nice day when they found out they were facing 1.2 million Yuan ($180,000) fines and a five-year market entry ban from the Chinese Securities Regulators. According to a Nov. 10 Reuters article, regulators believe they were speculating with an undisclosed leverage in their astronomical amount of equity purchase attempt to buy a publicly traded company in late 2016. The securities regulator explained in its notice that Zhao and Huang planned to acquire over 29 percent of the shares of the public company, but they planned to pay only 60 million Yuan ($9 million) from their own pocket and borrow the rest: 3 billion Yuan ($450 million USD) — a leverage up to 51 times.
When the disgruntled couple travel to and from Beijing in bullet trains, they might not realize that while the state-owned China Railway Corporation is rapidly constructing high-speed railroads from the Gobi Desert to the tropical island Hainan and abroad, the debt of the giant corporation is growing at an equally rapid speed. It is rising from 4,100 trillion Yuan ($616 trillion) at the end of 2015 to 4,720 trillion Yuan ($708 trillion) at the end of 2016 — an increase of 620 trillion Yuan ($93 trillion), compared with 419.6 trillion Yuan ($63 trillion) in the previous fiscal year, according to the annual reports of the corporation.
They are not alone in this party. According to Financial Times estimates, the corporate debt in China has risen to over 160 percent of its gross domestic product. Similarly, total debt — corporate debt included — has risen from 147 percent of GDP in 2007 to 279 percent in 2016. Actually, every one Yuan increase in China’s nominal GDP accumulates six Yuan new debt. Given that, it would be surprising if no one is concerned with the risk of debt default, and a following financial crisis like the one in 2008-09 after the collapse of the American housing market. Actually, a 2017 International Monetary Fund report warns that “International experience suggests that China’s credit growth is on a dangerous trajectory, with increasing risks of a disruptive adjustment and/or a marked growth slowdown.”
So, how dangerous is the debt problem of China? I would cautiously say it is highly possible for China to successfully avoid a debt crisis in the near future, but without further economic structural reforms, some financial crisis or even economic recession is imminent.
Why? Well, when we talk about the debt of China, one point should always be in mind: characteristics of the Chinese economy. Although China is now far from its centrally planned economy decades ago, the past still partly remains and influences its economy today.
If you break down China’s debt structure, the government and household debt is not large, and the main proportion is corporate debt. Most of the corporate debt is that of state-owned enterprises, like China Railway Corporation, while the major creditors are largely state-owned financial institutions, as the newest Macquarie's Global Macro Outlook Report states. Compared with complete market economies, China has a lot of room to maneuver between state-owned enterprises, state-owned financial institutions and the government. Actually, what China is doing right now is mediating between creditors and debtors, promoting a measure called “debt-to-equity swap” for debt restructuring while maintaining financial stability.
Secondly, although there are more than 4,000 institutions in China's banking sector, the five major state-owned banks account for about 40 percent of the total assets of the sector, according to a June 27 Financial Times article. Because the largest Chinese commercial banks are largely state-owned, they are endorsed by the government. Dating back to the 2000s, the overall bad debt rates of Chinese banks once exceeded 40 percent, but no bank runs happened at all. It shows the strong market confidence that these banks’ credit is equivalent to Chinese sovereign credit. In other words, these banks will never be bankrupt unless China goes bankrupt — “Confidence is the most important thing, more important than gold or currency,” said former Premier Wen Jiabao. The strong confidence ensures a low possibility of bank runs, and the sufficient liquidity needed in the banking system.
What’s more, notice that China's debt is mainly domestic debt, while debt in foreign currencies accounts for less than five percent of total debt, and China also has fairly high foreign exchange reserves and trade surplus over all other major economies, all of which are essentially different from other emerging economies in Asia that have historically experienced debt crisis.
So these are China’s “buffers” — its strong control over the market and the expectation that the government can and will promptly inject money into the market and stabilize the market sentiment. These characteristics buffer China from falling into a debt trap instantly. Nevertheless, despite the many “buffers” China has, it is still quite luxurious for policymakers to have sweet dreams.
There is a term called the “Minsky Moment,” named after the American economist Hyman Minsky, who predicted a sudden major collapse of asset values after long stretches of prosperity and high returns of investments which led to increasing speculation using borrowed money. If the income generated by the assets is no longer sufficient to pay off the debt, losses on such speculative assets prompt lenders to call in their loans. Suddenly the number of sellers dramatically exceeds the number of buyers as so many people want to sell their assets, triggering a plunge in asset prices and further sell-offs.
It is still debatable whether China’s buffers and measures are solving its debt problem or just delaying it. An already decreasing savings rate, the informal leverage and financial derivatives in shadow banks, and a one-fourth slump of foreign exchange reserves in 2016-17 are all worrying, not to mention the historic structural problems such as an aging population, and potential geopolitical conflicts in the region (e.g. North Korea).
At least one thing is certain; If a nationwide debt crisis, or the Minsky Moment, breaks out, the consequences will be much more catastrophic, and much more globally spread, given China’s $12 trillion economy and its trade and direct investment relations with the rest of the world.
— Editor's note: An earlier version of the article incorrectly stated that Zhao Wei and her husband intended to borrow 3 trillion Yuan ($450 billion) when it is in fact 3 billion Yuan ($450 million).