The Chinese Communist Party is now officially worried about mounting debt. “A tree cannot grow up to the sky—high leverage will definitely lead to high risks,” said a front-page commentary in the People’s Daily on May 9. The author of the commentary was identified as “an authoritative person,” usually code for the top leadership. “Any mishandling will lead to systemic financial risks, negative economic growth, or even have households’ savings evaporate. That’s deadly.”
Liberal lending has been a part of the economy for years. The concerns arise now because the expansion of debt is approaching critical levels. In the years since China unleashed billions in loans to weather the global financial crisis of 2008, overall debt has grown from 164 percent of gross domestic product to 247 percent last year, Bloomberg Intelligence estimates. Household and central government debt are still manageable at 41 percent and 22 percent of the economy, respectively, but corporate debt, at 165 percent, is much higher than in most developing countries.
At the same time, President Xi Jinping wants to deliver economic growth of 6.5 percent. To hit that target, the government will need to lend to companies to keep them going. Many are already in rough shape. With the steel, coal, cement, and real estate industries suffering overcapacity and falling profitability, corporate defaults are likely to rise, say S&P Global Ratings and Fitch Ratings. Nonperforming loans could already be as high as 19 percent of loans outstanding and could rise to one-quarter, far higher than the official estimate of 1.67 percent, warns Francis Cheung, a strategist at brokerage CLSA. Potential losses could amount to as much as 9.1 trillion yuan ($1.4 trillion), or 13.5 percent of GDP, Cheung estimates.
During the crisis at the turn of the century, China created four asset management companies to take on bad debt from the four giant state banks. There now are 22 local AMCs, says Chen Long, China economist at research consultants Gavekal Dragonomics in Beijing. The new AMCs often take on debt that banks have agreed to buy back later, a dodge Chen calls “warehousing.” That helps banks clean up their balance sheets in the short term and lowers the capital they must set aside to cover the cost of soured loans. Although the China Banking Regulatory Commission has tried to crack down on warehousing, “institutions always find new ways to get around the rules,” Chen says.
Officials have announced that banks burdened with bad corporate debt will be encouraged to swap the loans for equity, becoming shareholders of the troubled borrowers. Regulators plan an initial debt swap valued at 1 trillion yuan, reported the English-language website of financial publication Caixin, citing an unnamed executive at China Development Bank. Participants include Bank of China, Industrial and Commercial Bank of China, and China Minsheng Banking.
Bad loans will also be securitized and sold, likely to other banks. It’s unclear how steep the discount on the securitized debt will be. Debt swaps and securitizations “are not solutions per se and could backfire. They could allow weak/nonviable firms to keep going,” warned the International Monetary Fund in an April report.
China’s leaders seem intent on avoiding significant job losses before a crucial Communist Party Congress next year. They know unemployment would rise if weak companies couldn’t borrow. So corporate debt will probably keep on rising and could be 10 percentage points higher by yearend, predicts Gavekal’s Chen.
China’s low rate of external borrowing, capital controls, and state ownership of the banks make it less vulnerable to a sudden loss of credit, says Louis Kuijs, head of Asia Economics at Oxford Economics in Hong Kong. “People are still happy to put their money in the banks,” he says. “And liquidity drying up is what creates a financial crisis.”
Instead, China risks falling into a pattern of chronic low growth, much as Japan did starting in 1990, as ever more credit is required to fuel a slowing economy. In China last year, 10 percent of new credit went toward servicing existing debt, UBS Securities estimates. “They may never deleverage—Japan never did,” Chen says. “But then you are stuck long term with slower growth. You end up with a lot of zombie companies holding back the economy.”
The bottom line: Losses from bad loans might equal as much as 13.5 percent of Chinese GDP, yet policymakers prop up loss-making companies.