Why China's Debt Levels Are All About Property Prices

Real estate holds the key to the debt-leverage divergence, Nomura says.

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Residential and commercial buildings stand in eastern Beijing, China.

Photographer: Nelson Ching/Bloomberg

Have you been mixing up your Chinese debt with your Chinese leverage?

If so, economists at Nomura Holdings Inc. want you to stop that right now.

In a note published this week, they argue that the conventional wisdom that "debt" and "leverage" are basically the same doesn't really work for the world's second-largest economy. In fact, the two have actually been moving in completely opposite directions over the past decade, with China now exhibiting "high debt but low leverage," economists led by Yang Zhao and Wendy Chen write.

China's corporate leverage, which Nomura measures by an average debt-to-equity (or asset) ratio, has been kept in check thanks largely to rapidly increasing fixed asset investment (FAI) and a bullish real estate market, they argue.

Meanwhile, Nomura estimates that the amount of debt actually held by China's non-financial companies, households, and governments reached 158.5 trillion yuan ($24 trillion), or 231 percent of annual GDP, at the end of last year. Total borrowing by both non-financial and financial sectors is closer to 211.8 trillion yuan, or 309 percent of GDP – compared with 78 percent back in 2007.

Source: Nomura

"The combination of high debt and low leverage may not necessarily last long. From the above analysis, property prices are a key variable in determining the leverage ratio," the analysts write. "A high debt-to-GDP ratio could usher in a high leverage ratio through a sharp correction of property prices. Although China’s current leverage ratio remains low, it could spike if property prices drop significantly. This is why policy needs to prioritize the stability of property prices."

As the property sector is an important part of capital formation in the country, housing prices are what analysts at Nomura Holdings Inc are paying attention to in analyzing the debt issues in China. Housing investment contributed around 25 percent of FAI on average between 2003 to 2015 and housing prices in China's top-tier cities surged 4.5 times on average between 2000 and 2015.

Source: Nomura

All in all, this means that we will see China joining the ultra-low interest rate club in the next two to three years. At issue is the degree to which the country can lower its debt-to-GDP ratio by boosting FAI further — that's a tough ask given that around 70 percent of FAI is funded by debt, according to Nomura. Instead, China might be able to manage down its debt by lowering borrowing costs and devaluing its currency.

"A tricky associated issue here is the renminbi exchange rate, as cutting interest rates bring depreciation pressure," said the analysts. "We believe the best strategy for the [People's Bank of China] is to devalue the currency first and then cut interest rates."

Specifically, Nomura estimates that USD/CNH will reach 7.1 at the end of 2017 while China's one-year benchmark deposit rate will be below 1 percent.

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