Why China's Debt Bubble Won't Burst
Is China facing the prospect of a financial meltdown? That’s a question gaining new urgency as its economy decelerates: Growth in the second quarter came in at 7.5 percent, its second consecutive decline. Total debt now amounts to more than $17 trillion, or an astonishing 210 percent of gross domestic product, up 50 percentage points from four years ago, estimates Wang Tao, chief China economist at UBS Securities.
The scale of the problem suggests the worries are well founded. Take China’s highly leveraged corporate sector. Company debt reached 113 percent of GDP at the end of 2012, up from 86 percent in 2008, when the country’s leadership directed banks to open their lending spigots during the financial crisis, estimates Louis Kuijs, chief China economist at Royal Bank of Scotland in Hong Kong. Making matters worse, the biggest company borrowers—state-owned enterprises in heavy industries like steel, aluminum, solar, and ship-building—are now saddled with overcapacity funded by the easy credit.
A significant portion of new lending is going towards paying interest on old loans, according to UBS’s Wang. “Manufacturers facing oversupply issues will be the most likely source of new non-performing loans for banks this year,” says Liao Qiang, director of ratings for financial institutions at Standard & Poor’s. “And next year banks will see growing pressure, from [stressed] property developers, construction companies, and local government borrowers.”
While the officially reported level of bad loans is still very low—just under 1 percent for commercial banks as of the end of last year—that is likely understated. Local government borrowing—in part through China’s largely unregulated shadow banking system—has surged in recent years and now amounts to about one-third of gross domestic product, according to UBS. Much of that money has been pumped into infrastructure projects and property developments that will not provide returns for years. If China’s property markets cool, local governments—heavily reliant on land sales—may start to default on their loans.
While many analysts are becoming gloomier about China’s economy, they acknowledge that there’s very little risk of a systemic crisis. Capital controls protect China from the outflows that triggered financial meltdowns in countries including Thailand and Malaysia in the late 1990s. Also, China’s external debt is very small, only 7.2 percent of GDP, points out Royal Bank’s Kuijs, so a change in sentiment by foreigners would not have much impact.
With its high personal savings and $1.7 trillion in net foreign assets, China has ample resources to bail out banks and ailing industries. Kuijs figures that even under a “severe stress” scenario, where one-third of loans went bad, the cost of a rescue would push up government debt by only seven percentage points, to a still-manageable 60 percent. “It would certainly be messy. But China has the fiscal wherewithal to absorb problems like this,” he says. UBS’s Wang is also sanguine. “The level of debt is not a good judgment of whether a country has a serious problem,” she says. “The issue is whether it can afford the debt, and so far China can.”
China’s leadership is in no hurry to tackle the debt problem. In a recent meeting with economists, Chinese premier Li Keqiang stated that the nation’s leadership would not allow economic growth to fall below 7 percent. Says Shen Minggao, head of China country research at Citigroup. “If China wants to lower its debt, then growth has to be lower. Eventually they will have to choose.”