The Riddle Behind China's Debt Issue

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Includes: CHN, CN, CNY, CXSE, CYB, FCA, FXCH, FXI, FXP, GCH, GXC, JFC, MCHI, PGJ, TDF, XPP, YANG, YAO, YINN, YXI
by: Walter Hin
Summary

According to the McKinsey Global Institute, China's debt has reached to 282% of its GDP, up from 2007 when it was at 158% of GDP.

Chinese data is contradicting one another. For example, increasing the money supply and services as a percentage of GDP should lead to inflation, instead it is tamed.

The growth in Chinese banking assets has not only surpassed the U.S. (back in 2009-10), it is now $13 trillion bigger.

Despite the debt increase, China's cost of borrowing remains stable when measured against its 10-year government bonds and borrowing costs.

However, symptoms like bubbles in its stock market is a step back from rebalancing its economy and the continuation of its old growth model.

Intro

China's debt time bomb is mentioned from time to time in the mainstream financial media. One day you hear about the problems in China's local government debt and the next month there's an article explaining about its corporate debt overhang.

The confusion lies in the Chinese economic data, where some data contradicts others. For instance, China's GDP coming in around 7%-8% when house prices are falling, inflation is dropping, manufacturing is stagnating and retail sales growth is slowing.

For China's observers, it is best to get a balanced view of the country's economy and drill down to undeniable facts of what is going on and what is being said and seen.

Different countries under different circumstances will feel the bubble popping at various stages in the credit cycle. However, certain things remain true, and that is, when an economy is leveraged up in debt it becomes harder to grow the economy.

For China, if it doesn't take the bitter pill to rebalance, it will find itself accumulating debt that could reach 350%, 400%, or even 500% of GDP. The bigger the credit bubble becomes, the harder it is to rebalance the economy.

Sometimes it takes a recession to force politicians' hands to rebalance their economy.

In the beginning: China is experiencing a credit issue, true or false?

China has been experimenting with the capitalist system for three and a half decades, and its living standards and lifestyle today compared with the past is as different as night and day.

Not saying that the capitalist system is 100% perfect, though, as it has brought some new problems to Chinese society such as environmental degradation and pollution, coupled with social pressure on youngsters to become successful in life.

Now things are not changing for the better in China, and talks of a credit bubble have been circulating in the mainstream financial press for the past two to three years. Not so long ago, China was praised for being a savior during the global economic crisis, as it launched a massive credit stimulus to boost demand at home and aboard.

Now that stimulus is coming home to roast, as it is becoming uncontrollable and has done more harm than good for China.

The naysayers have pointed to record debt growth and China's obsession with meeting its GDP target by whatever means necessary, even if it's unproductive.

Some of these unproductive companies are mainly state owned and are particularly involved in investment-led projects, causing capital misallocation.

The optimists point to Chinese savings, cushioning any credit event that may occur. And China's political flexibility to act quickly would be one way of getting ahead of the problem.

They also say that China's capital stock is low compared to Western economies, so stories of 'overcapacity' are greatly exaggerated, especially as it's the number one exporter in the world.

A recent study by the McKinsey Global Institute, titled "Debt and (not much) deleveraging", tells us how leveraged or unleveraged the global economy is. And one interesting finding is the leverage of the Chinese economy.

Chart 1: Shows debt to GDP ratio of China

At first glance, China's debt-to-GDP ratio is not that way off from countries such as the U.S., Germany and South Korea.

One needs to look at the speed of debt build-up to see how worrying China's situation really is, especially when debt growth went from 121% of GDP in 2000 to 282% of GDP 14 years later.

Assuming the information is right, how bad is the China debt situation compared to other credit events in the past which have led economies to experience significant recessions and depressions?

Comparing it to America

You may find it strange comparing China's economy to America's because one country is a producer and the other is a consumer.

However, the size and scale of the two economies would have far-fetching effects worldwide if either one starts to falter.

Chart 2

Chart 2 shows the history of U.S. debt as a percentage of GDP going back one hundred years. The speed of China's debt increase is astonishing if the great recession of 2008-09 is anything to go by.

To replicate a similar increase of 160% in debt to GDP, such as the case of China, in only 14 years is unprecedented!

That similar magnitude of increase in debt would have taken the U.S. nearly twice as long to achieve. The so-called deregulation period beginning in the early 1980s caused the U.S. to leverage its debt to GDP of 160% in 1980 to 375% in 2008, an increase of 215%.

That ended in a financial crisis.

Chart 1 shows another interesting observation. China's debt increase mostly happened in the last seven years, coming in at 120%!

But wait, there's more!

The changes in the U.S. and China's total banking assets chart (first appeared in Zero Hedge) suggests that China has been lending at a rapid pace. I have modified the chart using the latest information (see below):

Chart 3

(Source: Chinaknowledge.com, statista.com and research.stlouisfed.org.)

Even with the shocking graph above, we don't know if it includes 'Off-Balance Sheet Assets', known as shadow banking in both the U.S. and China, as statistics for such assets are estimates at best.

Traditional banking assets in China have surpassed that of the U.S. in 2009, and today it has $13 trillion more in assets than the U.S.

Given the size of China's economy is only 65% of that of the U.S., China is more leveraged than its U.S. counterpart in the traditional sense.

Digging into the evidence

Let's further analyze the makeup of what is being owed to whom to get a structural sense of the Chinese economy.

From Chart 1, I further broke it down into two new charts showing which segments are running up debt and which are benefiting from it (see below):

Chart 4

Source: McKinsey Global Institute

Chart 5

There are some interesting insights in Chart 4 about which sectors are doing the leg work for the economy.

The table below should further clarify the debt to GDP ratio in each of these sectors as being low, medium and high. I assumed 40% as being low, 40-70% being medium and 70%+ as being high.

Countries

Govt.

Household

Corporations

China

Medium 55%

Low 38%

High 125%

South Korea

Medium 44%

High 81%

High 105%

Australia

Low 31%

High 113%

Medium 69%

U.S.A.

High 89%

High 77%

Medium 67%

Germany

High 80%

Medium 54%

Medium 54%

Canada

High 70%

High 92%

Medium 60%

The make-up of which section of the economy owes what amount of debt is interesting in the case of China. Normal rules on which sectors incur the most debt would be split-up into two camps:

Camp 1: In a consumption-driven economy, you would see the household sector carrying the burden of the country's debt, while the government and corporate sectors reap the rewards through tax revenue and sales.

Camp 2: In a government-led economy (involving high-level of social welfare spending), the government would take up the country's debt burden. Corporations and households would benefit from contract hand-outs and social payouts.

In China's case, it falls into neither camps because both household and government debt to GDP is fairly low.

We know for a fact that China's economy has been averaging 8% plus in the last decade. But how it has been able to maintain such low debt-to-GDP ratio levels for the government and household sectors for so long looks puzzling.

For a fair and comparative assessment, we need to compare it to another country with a similar economic model, and Germany comes to mind.

Germany is the largest European economy (known as the 'big boss' in Europe). Its economy has low household consumption with emphasis on exports (mostly higher-value) and at the time it was integrating East Germany with West Germany by upgrading infrastructure and so forth.

Germany vs. China - The lowdown

Here is a table comparison between the two countries:

Germany

China

GDP (Average in the last decade)

2%

8%

Govt's debt to GDP

80%

55%

Corp.'s debt to GDP

54%

125%

Household's debt to GDP

54%

38%

To answer the above questions about China's low debt-to-GDP ratio, we can say that Germany, despite growing much slower than China, runs a trade surplus higher than China (as a percentage of GDP). Also, Germany requires government spending and some household spending to act as support (both higher than China's) to keep its economy averaging a 2% growth.

Chart 6 and Chart 7 below compare Germany's and China's trade balance and trade surplus as a percentage of GDP.

Chart 6

Source: Trading Economics, Statistic

Chart 7

Source: Trading Economics

Comparing the two charts, we can all agree that Germany has been running the higher trade surplus as a percentage of GDP than China. Also, we can agree that Germany's government and household spending is higher than China's as a percentage of GDP.

This brings us to the next question: How has China been able to achieve an 8% average growth in the last decade if Chinese data point to low household and government spending, along with trade surpluses not being enough to grow it at that pace, in the first place?

The answer lies in a combination of the following things.

First, the way China calculates its GDP is via the 'production approach'. Using that method, GDP is calculated by estimating the values of its production and construction of goods and buildings without knowing if it can be sold off at that value.

It also explains how the country manages to be the first among major economies to report its GDP numbers (within three weeks of the quarter ending), ahead of other major economies like the U.K. and even Hong Kong (despite having a smaller economy than China).

Furthermore, China doesn't revise its economic numbers as fast as other major economies. Instead, you will need to wait for the revision every five years.

Second, we could believe the naysayers and assume China's growth in the last three to four years is not 7-8% by cross-referencing its other economic data that point to falling industrial production, declining house prices (of recent times), slowing retail sales growth, and now declining imports and exports.

Still, it doesn't explain how China can grow its economy at a rapid pace, even at 4% without incurring debt in other segments of its economy.

The answer is from borrowings.

High Chinese corporate debt = High GDP growth

The 'subheading' may sound controversial, but it's true.

Not everyone may know this but most Chinese corporations are mostly state-owned enterprises with political links. They are also viewed favorably by the (State-owned) Chinese banks when it comes to lending.

Even those that are classified as private enterprises have owners who have a relationship with the Chinese government either through supporting of its policies or by being a member of the Chinese Communist Party.

The 125% of debt-to-GDP accumulated by the corporate sector leads us to believe that China's investment-led economy is still its 'bread and butter.' But how important is China's infrastructure to its economy?

According to a report by The Economist in 2010, the current pace of construction in China is equivalent to building Rome in only two weeks.

Okay, so what does it all mean?

Rome is the capital of Italy (obviously!), and the city has a population of 2.8m people.

So in a year, China would have built 26 Romes (52 weeks ÷ 2 weeks) and would be able to house 72.8m people (2.8m × 26 Romes), hypothetically. And we are only talking about 2010!

In fact, it is no surprise that China is running out of designs for building projects. And the fact that they started replicating famous landmarks around the world like New York's Manhattan, or the White House means they are building for the sake of building!

More importantly, how many more 'Romes' were built in China in 2011, 2012, 2013, 2014, etc.?

Let's look at one statistic that is relevant to the overbuilding issue: Gross capital formation. It is a measure of all things to do with investments, including schools, factories, roads, homes, etc.

Chart 8

Source: NBS of China

China's gross capital formation still plays an important role in its economy. When The Economist remarked about China building Rome every two weeks in 2010, it spent close to 18.362 trillion RMB ($2.87 trillion) in capital investment. That figure has risen to 26.908 trillion RMB ($4.37 trillion) by 2013, a 46.5% increase.

So, how many Romes have China built in 2013?

In 2010, it built 26 Romes, and by 2013, that pace has reached 38.1 Romes, hypothetically speaking. And how many homes would that accommodate? Taking the 72.8m people figure in 2010, that translates to 106.6m people, again hypothetically speaking.

Think about it, China is building enough homes to accommodate about 107m people in one year, or 7% of the entire population, that is one-third of the U.S. population.

Comparing it to the U.K. and U.S.

The U.K. homes completion figure stood at 109,370 in 2013. Assuming each home accommodates an average of 4 people, that would house 437,480 people. The U.K. population is 64.1m, so homes built per year is equivalent to 0.63% of its population.

Since the U.K. is developed, it doesn't need to build a lot of homes than it did in the past. In fact, the highest number of home completion was 425,000 homes in 1968. Again, assuming 4 people per home, it equates to 1.7m people, or 3% of the entire population at the time.

In the U.S., homes completion stood at 883,800 in 2014. Like the U.K. assume each home accommodates 4 people, therefore housing 3.535m people. The U.S. population stood at 318.9m, therefore representing 1.1% of the entire population.

Housing completion in the U.S. was highest in 1973 at 2.1m new homes completed, housing roughly 8.4m people, or 3.96% of the U.S. population.

However, China has the fifth highest home ownership in the world, coming in at 90%, compared with 64% in both the U.S. and U.K.

With such a high ownership rate in China, it wouldn't be productive to build even more homes for the sake of achieving its GDP targets and risk huge maintenance costs in future years when someone does buy and occupy the property.

An FT article mentions China's property inventories would take seven years to be sold off!

A separate article from WSJ states that 1 in 5 homes remain unoccupied in Chinese cities, or 49m units. The number only accounts for the urban parts of China and don't include the rural parts. At the same time, China is experiencing a demographic issue of a lower number of young people (a separate issue to this article).

Breaking down China's debt growth and GDP growth

Despite pieces of evidence of a massive credit growth in China from various sources, even sources from within China itself, China still thinks it has got credit under control.

China has devised a measure called 'Total Social Financing (TSF)*' which is supposed to give an accurate picture of credit growth. (*TSF is made up of the following: RMB loans, foreign currency loans, Bankers' acceptances, entrusted loans, corporate bonds and equity financing.)

However, credit growth cited from TSF has grown at the same pace as its GDP (see Chart 9 below).

Chart 9

Source: Quandl

A better measure to assess the changes in credit growth is to use China's money supply (M2) versus the overall size of its economy.

Chart 10

Source: Trading Economics, World Bank

Chart 10 provides us with two important observations, they're:

  1. Money supply (M2) and the overall size of the economy has been running parallel to one another from 1996-2006 and the increase in borrowings have been coming from bigger trade surpluses from 2000 onwards.
  2. From 2008 to present, the monetary base has achieved liftoff as it outpaces the size of its economy.

That coincides with China's launch of its four trillion Yuan stimulus package to counter its exports slump from Western economies with massive infrastructure projects. So, Chart 9 and Chart 10 contradict one another. In Chart 9, the 2009 stimulus package appears to be a temporary fix, while Chart 10 shows the continuing increase in stimulus to the present day.

Some people would argue by saying the changes in money supply do not necessarily contribute to a credit bubble because China:

  1. Still has a high savings rate, this reduces money velocity;
  2. Inflation in China is rather tamed;
  3. The RMB hasn't depreciated but has appreciated against the USD in the last six years;
  4. Household and government debt-to-GDP is low in comparison to Western and other emerging economies; and
  5. Exports from China are booming and it recently became the number 1 exporter in the world.

All of the above are true to some extent if you have full faith in its data.

Here is why the Chinese data on its services sector is contradicting itself:

Chart 11

(Source: World Bank)

Why increase the money supply (that is print new money) if the service sector is becoming more important to the economy?

Chinese household debt did increase from 8% of GDP in 2000 to 38% of GDP today, supporting the so-called rebalancing theory, as services as a percentage of GDP moved from 39% to 48% in that period. However, mixed with newly-created money, shouldn't it spur runaway inflation in China?

Because when households start spending more of their savings for consumption, then the money velocity should increase at a faster pace as one Yuan moves from one transaction to the next more frequently. Therefore, that same Yuan gets counted two or three times in its GDP (for emphasis)!

Instead, China's inflation remains tame, causing contradiction to its data. Or, is China able to defy the rules of monetary theory?

In my opinion, there is more evidence supporting the facts that China is an investment-led economy, and why Chart 8 paints a more accurate picture.

Chart 12

(Source: Chinaknowledge.com, statista.com and Trading Economics)

Chinese data on its total banking assets have exploded and that lending has increased further since 2009, as the 'Assets-to-GDP' ratio has increased from 2 to 2.5, coinciding with its stimulus package in 2008-09.

So, why are banking assets in China playing a role in telling us that there is more debt growth than GDP growth?

NB. The asset side of a bank's balance sheet tells us about lending money to various segments of the country's economy.

For instance, Chinese bank lending to customers is quite robust (see below).

Chart 13

(Source: Annual reports from BOC, ICBC and Construction Bank of China)

With increasing bank lending and advances to customers in record amount year after year, which supports the fact that money supply is increasing, still Chinese inflation remains very tamed by historical standards.

The question is: Who are these customers the banks are lending to?

Remember, what The Economist has said about China building an increasing number of Romes every year. That is where the money has been directed, thus explaining why money supply has shot up, bank lending has shot-up and inflation remains tame.

The corporate borrowings done by China's SOEs is for the purpose of increasing production capacity. Private companies would find it hard to borrow, but more importantly they focus on the demand side, meaning they make things that people want to buy, not for display purposes.

At the end of the day, corporate debt from SOEs are the responsibility of the Chinese government; if these companies find themselves in a liquidity crunch, the government will be there to bail them out.

The question is: how many of these SOEs will need to be bailed out by the government?

However, something is missing in this debt binge that China has been feasting on, and that is the cost of all this borrowing.

The cost of borrowings

Chinese borrowing costs have been stable in the ten-year government bonds and its lending rate, despite the latter seeing three interest rate cuts in a matter of months.

Chart 14

One needs to look at short-term borrowing costs such as the SHIBOR, or China's interbank rate, to notice the faintest of liquidity squeezes. The first was in 2007 when the stock market bubble was about to burst. The second was in mid-2013 as property prices started to slow. The third was around early 2014, but Chinese authorities prepared for it by injecting liquidity.

Future spikes in the interbank rate can signal future bubbles like the Chinese stock market.

Chart 15

(Source: World Bank)

Another reason the cost of borrowing has remained steady is debt gets rolled over in China through the continuation of new borrowings replacing old borrowings. That means Chinese banks do not have to write-off bad loans that get reported in the 'Non-Performing Loans' section, hence NPLs are at record low, despite GDP growth being weaker than 1999, when NPLs were near 30%!

The solutions to rebalancing China's economy and the bitter pill to swallow

Putting the credit issue aside, let's focus briefly on the meaning of China rebalancing its economy.

China's over reliance on investment has run its course and any continuation will just make the credit bubble worse because it will take more borrowing to eke out the same amount of GDP.

However, rebalancing is a bitter pill to swallow because it means laying off workers, in the tens of millions (if not the hundreds of millions), and that could potentially lead to civil unrest. The second problem with rebalancing the economy is, where are these laid off workers going to find another job?

China may have the political flexibility to act in times of crisis. However, the party does not want to swallow the bitter pill and do what is right for the long term.

The fact that China is brewing another bubble in the stock market is a sign that the country wants to keep the old model going.

For example, the participants to the rise in the Chinese stock market today are mostly retail investors (accounting for 90%). Unlike the last crash in 2007, this time around retail investors can finance trades on margins.

These companies listed are mostly state-owned companies looking to raise equity to reduce financial leverage, hence why corporate debt is too high in China.

However, if the stock market bubble does pop, the misallocation of money from ordinary Chinese people (those that participated and lost money) to the SOEs (those that are receiving liquidity from share sales and equity issue) is evident of China's step backwards.

In my opinion, the stock market bubble is another form of financial repression (as explained above).

Therefore, it doesn't help China towards rebalancing its economy, instead it just pursues the old forms of growth by reallocating savings to inefficient SOEs.

What China should be doing? - My opinion

China should be following the economic model of Japan and South Korea when both shifted from investment to innovation and invention. I understand why China is building infrastructure, especially in the hinterland where it remains undeveloped.

Instead, it should try to replicate the success achieved in Shanghai, Beijing and Guangdong.

What do I mean?

If you want to develop the Western region of China, isn't it best to invest in the talent first instead of buildings because talent takes time to be developed, so reallocating some capital into education is one way to go about it.

Summary

China's debt issue is a growing problem because the misallocation of resources is becoming worse. Data showing the service sector is growing at a rapid pace is a little misleading due to the fact that inflation is tame when the money supply is exploding at a rapid pace.

Therefore, investment is still the 'bread and butter' of the country's economy.

There are signs that the investment-led model is likely to continue, as authorities are talking up the stock market and ordinary Chinese people are taking part in trading stocks with their savings, earnings and borrowings.

The talk of reform and rebalancing is just talk, but a continuation of the investment-led model will lead to higher and faster debt to GDP growth, which will put the Chinese economy into a bigger credit bubble.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.