China's Dangerous Debt Drag
Few buzz phrases scare economists more than "new paradigm." If such things existed, Japan would still dominate the world economy, risk would have been eliminated from Wall Street, and the euro would have spread boundless prosperity from Berlin to Athens.
So why do so many market observers continue to insist that basic principles of growth and stability don't apply to China? News that exports fell 3.3 percent year on year in January, while imports fell 19.9 percent -- the most in more than five years -- don't seem to have fazed many analysts. Bloomberg China economist Tom Orlik points out that the numbers may have been skewed by pre-Lunar New Year buying last year and a crackdown on mis-invoicing of exports to Hong Kong. More broadly, though, optimists are simply convinced that President Xi Jinping will soon introduce more stimulus measures to keep growth ticking above 7 percent.
The idea that China can borrow indefinitely in order to prop up growth simply doesn't wash. In a new report on the world's growing debt glut, McKinsey highlights three huge risks: unsustainably high government borrowing, households in over their heads and China. The mainland earns its singular position because of another trio of concerns: too much debt concentrated in real estate; the scale and complexity of its shadow-banking entities; and rampant off-balance sheet borrowing by local governments.
Driven by the vast shadow-banking sector (which contains at least $6.5 trillion of debt) and a construction boom fueled by local officials, China's debt buildup accounted for a third of all borrowing globally since 2007. In that period, total Chinese debt quadrupled to $28 trillion by mid-2014 from $7 trillion. China's public debt now stands at 282 percent of gross domestic product -- a far higher debt ratio than that of advanced economies like the U.S., Germany and Australia.
Why does that matter? When investors scrutinize China's balance sheet, they're looking for immediate threats -- what might trigger a true financial meltdown. One could make the case that with almost $4 trillion of currency reserves, vast state wealth and a controlled financial system, China can head off any crisis by bailing out developers and propping up stocks.
Yet, as McKinsey notes, high debt levels don't just raise the risk of a dramatic crash: They "have historically placed a drag on growth." The problem is diminishing returns. As Japan proved over the past two decades and Europe confirms, highly-indebted nations require ever-bigger stimulus injections to lift GDP. Economists at the International Monetary Fund generally put the drag-on-growth threshold at about 96 percent of GDP -- a line China long ago blew past.
For an advanced economy like Japan, this poses a difficult problem. For China, which has yet to reach middle-income status and must still lift tens of millions of citizens out of poverty, it's hard to distinguish from a crisis. Expanding public debt risks suffocating a private sector that's still in its infancy. The cost of servicing that debt will hog resources that could otherwise be invested in education, healthcare and productivity-increasing technologies. New airports, six-lane highways and skyscrapers will produce more overcapacity than household demand.
What's the answer? The most obvious is to allow growth to decelerate to the 4 percent to 5 percent range needed to wean China off excessive investment and debt. That would help purge Beijing's excesses, including the rampant corruption Xi has pledged to eliminate. It also would give the government room to rein in state-owned giants, which live off of easy credit.
Barring such shock therapy, the government could develop, as McKinsey writes, "a broader range of tools to avoid excessive borrowing and efficiently restructure debt." Half the loans made since 2007 are linked to the cooling real-estate sector. A wider range of financial products, a broader pool of intermediaries and tax incentives to issue non-property debt would reduce risks. Beijing should clamp down on non-bank lending, America's downfall in the late 2000s. A broader array of debt-restructuring mechanisms -- like stronger investor-rights clauses -- would curb irresponsible borrowing.
China should also employ more so-called macroprudential tools to deflate bubbles. The government could impose tight limits on loan-to-value ratios and ban risky mortgages like interest-only loans.
Finally, Beijing must get serious about improving transparency. Debt reporting is dangerously lax. The list of things we don't know is daunting: the breadth of shadow-bank lending; how much local-government financing is off the books; the scale of intra-local-government borrowing; the state of unfunded pension and health-care liabilities; the fitness of household finances. The first step to fixing China's problems is admitting just how bad they really are.
This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.
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