China’s systemic risk is rising. Its debt-service ratio is estimated to be high enough to trigger a financial crisis, leading some analysts to argue that the day of reckoning may be near. Maybe not. China’s debt problem is not yet fatal, as the crisis triggers are not present in China.
The Chinese system’s high non-performing loan (NPL) coverage will help it muddle through a deleveraging process and break the government’s implicit guarantee policy by enabling slow and orderly defaults. To prevent any systemic fallout, limited opening of the capital account and selective regulatory forbearance will remain in place in the medium term.
Official data show that China’s GDP growth rate has been trailing its credit growth rate by an increasing margin since late 2011. This suggests that rising debt has been supporting Chinese assets to produce income that is not sufficient to service the debt. This diminishing marginal efficiency of debt-financing has produced a “money black hole” that some analysts argue will eventually bring about a day of reckoning for China’s growing debt burden.
Money black holes have appeared in the Chinese economy before. In the last 15 years, there have been three episodes when rampant credit growth exceeded GDP growth significantly (Chart 1). So why all the fuss this time? The reason is that in all the earlier cases, the credit binge was driven by deliberate monetary policy expansion. Beijing “ordered” indiscriminate bank lending to salvage the economy from the impact of the external shocks stemming from the Asian crisis in 1998-1999, the bursting of the US IT bubble in 2001 and the Great Recession in 2008-2009.
However, the latest money black hole (which opened in 2012) is not policy-driven. It is flows from shadow banking, not bank credit, that have driven the rise in total liquidity since 2009. China’s debt situation is drawing international attention as it is growing so fast and is being driven by non-regulated shadow-banking activities. Recent Bank for International Settlements (BIS) research brought it into the spotlight.
The BIS found that when there was a fast run-up in the private sector debt-service ratio to above 25 percent of GDP a year, a financial crisis would follow in that economy. It cited the experience of the financial crises in Finland in 1991-1992, South Korea in 1997-1998, the US and Britain in the early 1990s and in 2007-2008, which were all followed by severe economic recessions. Worryingly, China’s non-public sector debt-service ratio is estimated at over 35 percent a year, according to our research.
However, the comparison of China’s situation with the other crisis countries is not appropriate at this point because the crisis triggers in the other counties, namely financial deregulation, a heavy foreign debt burden and an open capital account, are not present in China. Finland, South Korea, Britain and the US all aggressively deregulated their capital, banking and foreign exchange markets years before their financial crises erupted. All of them have open capital accounts, which make a rising debt burden detrimental as foreign capital pulls out en masse when foreigners lose confidence.
China’s financial system and capital account are still closed. Almost all of its debts are domestically owned, so China is not held hostage by foreign creditors at times of financial stress. Crucially, in all the estimates for China’s debt-service ratio, the key assumption is no debt rollover upon maturity. But Beijing has been rolling over domestic debt, especially that of the local government financing vehicles. Debt-rollover under a closed capital account will remain an effective measure to prevent any debt crisis from erupting.
The day of reckoning would come if China were to sit on its hands. But it is not. The leadership is moving, albeit slowly, to push for regulatory and structural reforms to help China deleverage. Its toleration of slow growth and resistance to indiscriminate monetary expansion in this cyclical downturn is a significant departure from the old bailout model. It is reacting to the shadow-banking problem with new regulations restricting bank lending to LGFVs, trust company loans to the local governments and banks’ and other financial players’ exposure to wealth management products.
Given the significant amount of rigidity and distortion in the system, China can only deleverage slowly. A too-big-to-fail policy and selective regulatory forbearance will remain in place in the medium term as costs for maintaining systemic stability. Small players, such as trust and other shadow-banking products, may be allowed to fail in the coming years as a transition to break the government’s “implicit guarantee” policy. But defaults by state-owned enterprises or LGFVs or any large players will be unlikely due to systemic concerns. Beijing must strike a balance between stability and structural reforms.
True, China’s systemic risk is rising. But it is not yet fatal, and Beijing is starting to tackle the problem. Its total (corporate, household and government) debt is lower than that of many countries. More importantly, Chinese banks have very high NPL coverage that can help absorb some potential defaults without much difficulty. According to the banks’ data, they have an average NPL coverage of about 300 percent, up from 40 percent in 2007 before the global financial crisis hit. Even among European banks, which have been struggling with an enormous amount of financial stress in recent years, their average NPL coverage has only risen by about 100 percent since 2008.
Unless some financial disasters arise, the odds of bank equity being wiped out (a common concern in the market) are low. Crucially, the steady increase in China’s NPL coverage since 2007 implies that the authorities might be preparing for some potential defaults. This is structurally positive if it indicates a policy shift from an implicit guarantee that distorts credit pricing to market forces that impose proper discipline on pricing capital.
Chi Lo is senior strategist of BNP Paribas Investment Partners (Asia) Ltd. and author of “The Renminbi Rises: Myths, Hypes and Realities of RMB Internationalization and Structural Reforms in the Post-Crisis World”.