Dissecting China's Debt Load

 

FEBRUARY 19, 2016 [ASIAN FINANCIAL CRISIS]
Charles Wilson, PhD


China's debt burden has grown substantially, but its debt profile, ample foreign exchange reserves and well-capitalized banking system bolster the country's ability to sustain it.

As previewed in the previous Dispatch, we are further exploring in this week's report a topic garnering much market concern – China's large and growing debt. China's total debt as a percentage of gross domestic product (GDP) grew to 250% in 2015 from just over 150% in 2005. China's debt-to-GDP ratio puts it in the same unhappy club of highly indebted nations, including the United States, the European Union members and Japan.

What drove the massive credit expansion? The main driver was a shift in the growth model from final consumption to one that was driven largely by corporate and government investment over the last decade, especially in response to the 2008 global financial crisis. The shift in the growth model helped to maintain high levels of GDP growth for a much longer period than many anticipated, in part due to the fact the central government could play a more direct role in driving the growth. A drawback of the new model was the high debt intensity. From 1995 through 2005, total debt grew at a compound annual growth rate (CAGR) of about 15.9% but then accelerated sharply to 23.1% between 2005 and 2015, with the fastest growth coming after the financial crisis (figure 1).

Figure 1: China's Total Non-Financial Sector Debt, USD Trillions

Source: World Bank

 

Giving credit where credit is due (pun intended), China has recognized that a debt-fueled growth model focused on domestic investment is not sustainable and more recently responded by reigning in credit growth. Prior to 2013, annual credit growth was running well north of 20% but slowed to about 15% since the start of 2014 (figure 2). In addition to slowing credit growth, China is shifting the growth model back toward domestic consumption, which, as we know from the 1990s, is much less credit intensive.

Figure 2: China Total Credit, Percentage Growth

Source: Bank for International Settlements

 

While China is making the necessary adjustments, this doesn't change the fact that it still has a lot of debt and much of it may not be serviceable. To put it in perspective, though, China's total banking assets reached just over $30 trillion in January 2016, according to the People's Bank of China. This is nearly two times U.S. bank assets and three times larger than Japanese banking assets. As noted, much of this growth occurred after the financial crisis. From the end of 2010 through the middle of 2015, global credit grew by $18.6 trillion. China represented $14.2 trillion of that, or roughly 76% of total global credit expansion over the period. No question - those statistics sound concerning.

Figure 3: China Banking System Assets, USD Trillions

Source: World Bank

 

However, many people fail to look on the other side of the ledger when evaluating China's debt burden. China has the highest national savings rates among both emerging economies and major developed economies at just over 50%. Assuming nominal GDP growth of 10%, banking assets grow at around $3 trillion per year but domestic savings grow at about $5 trillion per year, which International Monetary Fund data broadly reflect. The high savings rate suggests there should be no issue maintaining the very low loan-to-deposit ratio, which for many banks is in a global industry leading range of near 70%. Moreover, like Japan's, most of China's debt is domestically held, facilitating loan modification when necessary.

Figure 4: National Savings Rates, Percentage of GDP

Source: World Bank

 

Besides a well-capitalized and provisioned banking system, the Chinese government has a significant amount of assets which they can use to counter a crisis. Besides the obvious roughly $3.3 trillion in foreign currency reserves, the country also has significant ownership of a wide variety of large and important companies scattered throughout the Chinese economy. These companies operate everything from banks to ports and represent potentially more than $1 trillion in value. They are also some of the largest in the world by assets or market capitalization. This may be hard for foreign investors to conceptualize because government ownership of important companies isn't prevalent in Western countries. But it is still prevalent in China, where some state-owned enterprises are world class, and in many cases have significant liquid assets, including large cash piles and substantial ongoing free cash generation.

I'm not suggesting China's debt load is problem free. But I think the view that China's economy is on the brink of collapse is too simplistic and frankly outdated. Modern China is like its western counterparts in that it isn't one-dimensional. Its political system may be a one-party communist state, but its economy is better viewed as command capitalism, as paradoxical (or oxymoronic) as that may sound. In any event, it is, as noted, well capitalized. The current situation can persist for some time and improve as the transition to a consumer-led from an investment-driven economy advances. In the interim, there are many companies that will continue to grow faster than companies outside of China. More importantly for us, many of the most attractive Chinese companies are trading at very attractive valuations.

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