Will China’s debt mountain come crashing down?
China and commodity prices enjoyed a (brief) lift in investor sentiment in recent months in large part because of yet another debt fuelled round of housing and infrastructure related stimulus starting late last year.
Some suggest China can keep the economy chugging along in this way for some time, while other fears China’s debt mountain is about to come crashing down.
Who’s right? To my mind, the truth is somewhere between this extreme views.
China is not about to suffer a “hard landing” anytime soon as some impatient doomsayers like to suggest. Instead, China seems likely to suffer a slow descent into a Japanese style malaise. The good news – if you want to call it that – is that that the debt fuelled boom can likely continue for at least a few more years.
Let’s take a look at China’s debt.
Many analysts have noted that Chinese companies have built up a lot of debt since the global financial crisis, which has coincided with a slowdown in economic growth and loss in export competitiveness. Total Chinese debt to GDP has grown from around 150% of GDP in 2007 to around 240% - the overall level is still not that large by (developed) country standards, but a staggering increase in less than a decade.
Of course, all this begs the question: why is debt rising so rapidly? The answer is simple: China’s old way of growing its economy isn’t working profitably anymore, and debts are required to cover losses to stave of wrenching “US style” structural adjustment. China is trying to make this adjustment slowly but it’s reliance on state controlled enterprises and banks remains uncomfortable high.
China may never be able to wean itself of loss making traditional sectors.
The general perception, however, it to view this debt build up as a problem for the companies involved – mostly in the real estate and constructions sectors - and the banks that lent them the money. It’s also seen as a potential powder keg ready to explode.
The optimists, however, estimate that if push comes to shove the central government would effectively bail out the banks and corporate (many government owned) by issuing more of its own - still relatively low - debt.
According to estimates by McKinsey earlier last year, Chinese property related debt account for around 70% of GDP. If one third of this money was lost in a financial melt-down (50% loan default with only 25% of bad debts recovered), it would only raise central government debt from around 25% of GDP to 50% of GDP.
Effectively China is subsidising loss making enterprises with the funding being intermediated through the banking sector, and to a lesser degree by households through the so-called shadow banking sector.
So far so good. But the problem with this analysis is that I doubt the Chinese property market would ever be allowed to “blow-up” in such a US-style capitalistic way – and conveniently wipe out unprofitable firms and their debts. The economic fallout would be simply too great and a potential threat to China’s cherished political stability.
Instead, the Government seems more likely to keep “kicking the can down the road” as long as it can – through sanctioning ever mounting levels of debt to re-finance existing debts.
How bad could it get? Take a look at Japan. There, total debt to GDP ratio is 400% of GDP, almost twice that of China, while Japan’s government debt to GDP ratio of 250% - or five times larger than China’s.
A common view that China would sell some of its large international reserves to pay for the debt bailout seems misplaced: as the debt is local, not foreign, sale of reserve is both unnecessary and might unduly push up the Chinese Yuan in any case.
Instead, China’s mounting debt seems likely to be eventually pushed even more onto the still relatively unleveraged household sector – if only through giving them few other saving options than to channel funds to banks and “shadow” banks.
An alternative is that China – as in Japan – eventually resort to money printing to try and inflate away its debts. By that stage China might also be desperately trying to cheapen its currency to maintain international competitiveness.
For Australian investors this is a mixture of good and bad news. A Chinese hard landing remains unlikely, but ever weakening growth and rising debt does pose a risk for social (and even regional military) stability. And it’s hard a backdrop again which commodity prices are likely to rise strongly.
Published: Wednesday, May 25, 2016
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