China is undoubtedly important to the global economy and with embedded signs of rising bad debts, there are enormous concerns surrounding China’s ongoing stability.
Since 2005, China has accounted for approximately 40% of total global growth with the economy growing five-fold in just 15 years. However, jitters are now apparent and the past six months has seen the biggest test for emerging markets since the Asian crisis of 1997. A combination of three key factors are being cited; enormous growth in shadow-banking, bubbling asset markets and indebted local governments.
But just how likely is a financial crisis in China? What is their debt position in comparison to other countries and/or history? And what should an investor need to know in order to make educated decisions in related markets?
The Debt Expansion is Fearsome
A scary and newsworthy chart often put forward by media outlets shows the rapid growth in total debt across China. There are many versions of these articles, however even highly respected news outlets such as the Wall Street Journal (WSJ) and Bloomberg have caused stir with headlines such as “China’s Debt Bomb” and “A Debt Balloon With Nowhere to Go But Down”.
Of course, they are intended to inform their audience, but they also use such headlines to sell newspapers. Therefore, it is important to obtain a balanced view of the data.
The reality shows two important but contradictory points. Firstly, China’s debt has ballooned relative to history on both a nominal basis and in comparison to the size of their economy. In this sense, both the WSJ and Bloomberg are correct. However secondly, this debt expansion was from a very low base which means China is still in line with global peers on both a relative and absolute basis.
A Global Comparison
China’s total debt – accumulated by households, corporates and central/local governments – reportedly rose from 121% of GDP in 2000 to 158% in 2007 and 282% in 2014. This 161% expansion in debt looks unhealthy, but looks considerably worse in absolute terms.
Nominal GDP in China is estimated to have grown approximately 474% in the fourteen years to 2014, meaning the nominal total debt position has increased over 12x from around US$2.1 trillion to $28.2 trillion.
In comparison, no other country has ever encountered the same debt expansion on both a relative and nominal level. However, before everyone runs for the hills it is important to also illustrate the debt position of other key economies that many consider “perfectly safe”.
For example, the latest total debt figures – including public, corporate and household debts – show China has 282% estimated total debt to GDP, the USA has 269%, Germany has 258% and Australia has 274%. Relatively, all four countries have less debt than Japan’s governmental debt level alone.
Therefore, even after factoring in the misunderstood shadow banking, the Western World faces very similar levels of total debt as China according to the Bank of International Settlements. On this basis, China appears to be on track. The only problem is whether they can handle the next inevitable bad debt cycle.
Bad Debt cycles explained
It would be imprudent to brush off China’s debt expansion, including the shadow banking, on the basis of a global comparison. There are many valid reasons to be cautious about China’s debt expansion. Firstly, the composition of the debt is considerably different to its Western peers, with a much greater portion of higher risk corporate debt (especially lower grade non-financial corporate debt). In China, corporate debt represents 67% or two thirds of total debt compared to Australia which has less than half in corporate debt (47%) and the USA which has only 38%.
This debt composition is important on many levels, no less because it affects the speed and severity of any financial crisis, should it occur, plus it tends to lack the same levels of regulation and hence attracts riskier lending. This is a major risk for an economy known for volatility.
Bad and Doubtful Debts
Using the analogy of an individual that over-leverages on debt, it can be universally agreed upon that the greater the amount of debt relative to assets or income, the greater the risk of a severe collapse. For example, a couple earning $200,000pa with a $2 million home and a $1.8 million debt faces severe risk if either the asset or income falls. On the contrary, it also provides the greatest opportunity for growth if the asset value grows at a rate greater than the interest expense. On a country level, this is no different, and for China a high debt level creates this leverage.
The lesson from the “PIGS crisis” in Europe (the debt crisis of Portugal, Ireland, Greece and Spain) was that the real risk of a financial crisis comes from two sources; rising interest costs, typically beyond 7%, or a spike in bad and doubtful debts.
At present, the effective borrowing rate for China, assessed via its bond yield, is healthy at approximately 2.88%. Therefore, the real risk would be a spike in bad and doubtful debts, which is a key dataset to watch.
Will we see a spike in bad debts?
Whether we will see a spike in bad debts in China will relate to the ability of corporate China to meet its debt obligations. In the current environment, this is heavily reliant on three issues; 1) the overall exposure to resource-related debt, 2) whether the property market stabilises to constrain defaults, and 3) whether Chinese capital outflows can be constrained. In many ways, this is no different to the Western World, with the possible exception of capital outflows.
The biggest difference between China and its global peers is the historical analysis of bad debt cycles, with Chinese downturns far more severe and worrisome than Western counterparts. For example, a commonly cited downturn was the 1997 Asian debt crisis, which reportedly wiped more than 10% of bank assets in China. To put this in perspective, a similar episode today based on current Chinese debt levels would create a financial crisis up to 3.5x bigger than the 2007 crisis in the USA. This is scary stuff.
What to do?
It would seem contradictory to expect and/or fear a financial crisis in China without expecting something similar elsewhere in the indebted Western World. In reality, the backdrop of high debt and high asset prices are a common theme among many of the world’s most important economies.
Regardless of whether you think a crisis will occur, it is reasonable to worry about the impact a Chinese financial crisis would have on the global economy (including share-markets), particularly because of its size and historical volatility. Emerging market bond spreads are one way to monitor proceedings, as this is the markets way of telling us the risk of corporate debt, which China happens to have a lot of. Asset prices are another area to monitor, as a sharp fall in either property or equities could be an obvious trigger for a rise in defaults and the commencement of a bad debt cycle.
Patrick Hess from the European Central Bank said it well, when he was quoted as saying, “a domestic financial crisis is not unlikely to happen in China, and very likely to spread globally, should it indeed happen. To implement all the reforms necessary to avert a Chinese crisis is almost a “mission impossible,” or at least very difficult in the complex Chinese policymaking context, which involves a high degree of institutional overlap, conflicting goals and interests, and political bargaining. Even such a strong leader like Xi Jinping cannot change this context”.
At present, it could be plausibly stated that China faces its greatest debt-related risk since the 2007 GFC and possibly since the 1997 Asian Crisis, with capital outflows and asset values showing weakness. For now, Xi Jinping seems to be aware of the risks and we have seen the introduction of numerous reforms in recent times to counter or reduce these risks, and property values appear to have commenced a mild recovery.
Recent economic data shows the debt-train continues in China as it continues stimulating to avoid further capital outflows. However, rather ironically, the more China borrows the greater the risks become. In summary, investors should exercise a high degree of vigilance and monitor Chinese developments very closely.
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