China's Debt Situation: The Next Possible Financial Crisis?

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Includes: CHN, CN, CXSE, FCA, FXI, FXP-OLD, GCH, GXC, JFC, MCHI, PGJ, TDF, XPP, YANG, YAO, YINN, YXI
by: Global Risk Insights

China's debt situation is not only growing in size but also at a rate that economists and policy analysts feel is difficult to sustain. Adding to the problem is that China's public and private debt are intertwined and not helping the economic growth the nation needs to thrive.

Moody's recent downgrade of China's debt belies a substantial financial problem: Its huge dependence on debt to grow its economy. China uses debt as the key mechanism to build its infrastructure and expand businesses. However, the problem is that private and public debt are not only linked but that both are growing at unsustainable rates worrying economists and policy analysts. Compounding the problem is the role of shadow banking in China that, if the figures were available, would increase its debt tenfold.

Business debt problem

China's debt can be divided into private or business borrowing and public or government obligations. To expand their operations and be competitive, businesses borrow through bank loans and issuing bonds. This expansive lending has occurred for over a decade resulting in $21,600 in bank loans, bonds, and other debt obligations for each person in China. The problem is that businesses in China are state-owned enterprises (SOEs) run and owned by the government in order to keep people working. Loans come mainly from state-owned banks resulting in money being shifted from one pocket to another in the Chinese government accounting methodology.

Compounding matters is that Chinese businesses often guarantee each other's loans and debt obligations. This way of doing business makes it easier for a company to obtain a loan that would otherwise be very difficult. The state-owned banks complicate this situation by lending primarily to SOEs since they have implied governmental guarantees.

There is also the role of shadow banking. Shadow banking is bank-mediated business-to-business loans, allowing lending to occur when a potential borrower has been refused by a Chinese bank or not able to float a bond offering. Shadow banking has grown by more than 2 trillion yuan in the first quarter of 2017, approximately two times the amount in the last quarter of 2016. While shadow banking may offer financing possibilities and alternatives a Chinese business may not normally have, there is little to no regulation of these financial relationships that many analysts regard as opaque and susceptible to numerous problems. Currently, shadow banks fund approximately 20 percent of Chinese debt.

The really scary part of this problem, from a financial perspective, is the amount of debt. In 2002, Chinese debt was less than 20 trillion renminbi, but in 2016, it surpassed 160 trillion renminbi. In 2009, private corporate debt went from 9 trillion renminbi to 30 trillion renminbi in 2016, while SOE debt rocketed from 32 trillion renminbi in 2009 to 76 trillion renminbi in 2016.

Making matters worse are the currently accumulated bad loans totaling $317 billion according to official statistics, but some independent analysis estimates the amount at over $500 billion. This does not include $754 billion on a loan watch list that regulators fear may default. If the Chinese government were to approve a 1 trillion - yuan plan to deal with bad loans, this would only be a small start to solve an extremely large problem.

Chinese policymakers should be very fearful in the growth of corporate debt since the global financial crisis of 2008-2009. According to the Bank for International Settlements (BIS), Chinese corporate debt has gone from 96.3 percent of GDP in 2008 to 166.2 percent by the end of September 2016. Currently, the amount is 72.8 percent for the United States and an average of 105.9 percent for emerging markets.

Government debt problem

The explosion in public debt originated in the global financial crisis of 2008-2009. With global markets drastically decelerating, China's export-dependent economy suffered. With the global slowdown, many of China's factories closed resulting in approximately 20 million workers unemployed. China's leaders responded by instituting a $600 billion stimulus plan to build and boost the nation's infrastructure and provide jobs to its people.

The Chinese government decided to fund this plan through loans from its state-owned banks. Local government entities also wanted to boost infrastructure spending even though they were not permitted to borrow from banks or float bonds so they issued local government financing vehicles (LGFVs). This permitted taking on bank loans and issuing bonds, however, there is no exact figure as to how much was involved. The problem deepens since many of these infrastructure projects do not have sufficient cash flow to properly service their debt.

China and its local governmental entities continue to borrow which economists see as getting out of hand. For example, Chinese government debt has gone from 15 trillion renminbi in 2009 to 40 trillion renminbi in 2016.

Not only is China's massive borrowing a serious financial problem, but it has also become much less effective in helping to stimulate its macroeconomy. According to Francis Cheung, head of CLSA's China and Hong Kong strategy unit, "Stimulus is becoming less effective, requiring four units of credit for each unit of growth." If this trend continues, China and its local government entities will pay much more in order to borrow and ultimately get a lower return on every unit borrowed. Another analysis has shown that for each renminbi in credit in 2008, SEOs could make 0.7 renminbi in productive work. Presently, it is not even 0.25.

Can it get any worse?

Chinese leaders are extremely worried about other factors affecting the nation's debt situation. For example, if China's residential real estate market collapses, developers, construction companies, banks, and bondholders will suffer serious losses.

If interest rates in the United States continue to rise, funds will flee China, causing immense capital outflows. If President Trump imposes tariffs on Chinese goods into the United States, this will reduce demand causing China's economy to slow down.

This will cause businesses to fail and a high rate of debt default. China's current debt level is causing the nation to walk on eggshells it cannot afford to break.