Not long ago, China was a nation of savers. But it’s become a nation of debtors. And that’s a big risk to investors – in Asia and elsewhere.
A recent survey asked fund managers what they viewed as the biggest risks to the global investment environment. The second most-common response was “China devaluation/default.” (The first was the exit of Britain from the European Union).
A country’s total debt is the amount of money owed by its people, corporations and all levels of government. The total debt-to-GDP ratio shows how this debt compares to the total value of everything a country’s economy produces in a year.
China’s total debt-to-GDP ratio climbed from roughly 150 percent in 2007 to 249 percent in the first quarter of 2016. If China was a person, it would owe – car loans, mortgages, kids’ tuition payments, gambling debts – 3.5 times more than it earns in a year. (And remember… you don’t just pay off your debt from your income. You pay off your debt with what’s left after you pay for everything else – ongoing expenses to keep the lights on and the children fed and a roof over your head).
As shown in the graph above, China’s debt levels have been growing sharply in recent years. This is because the government has been engaging in its own version of quantitative easing.
For example, China’s central bank has made it a lot easier to borrow money, by pumping money into the system and by cutting interest rates six times since 2014. State banks have lent money to struggling businesses so that they can keep people employed and invest in new plants and facilities – even if it’s not profitable.
The Chinese government’s main goal is to boost slowing economic growth. For about 25 years after 1990, China’s economy grew on average 10 percent per year. But the law of large numbers means that – inevitably – this rate is slowing.
In the first quarter of 2016, China posted GDP growth of 6.7 percent, which was the slowest in 7 years (though it far outpaced GDP growth of 2.4 percent in the U.S. last year).
The problem, though, isn’t government debt. China’s government debt-to-GDP ratio in 2015 was only 44 percent. (By comparison, the U.S. has a government debt-to-GDP ratio of 105 percent). So there isn’t much concern about the Chinese government defaulting on its debt.
Debt owed by Chinese corporations, though, is between 160 and 165 percent of GDP. And state-run companies account for about 75 percent of China’s corporate bond market, which makes up a large portion of the corporate debt load.
So indirectly, the government is on the hook for a lot more debt than just public, or government, debt.
Debt is a serious drag on economic growth. A study by the World Bank estimates that for every percentage point above 64 percent in the public, or government, debt-to-equity ratio, emerging economies like China’s slow by 0.02 percentage points. (That’s because high levels of debt reduce the funds available for investment, and result in higher interest rates).
That might not sound like a lot, but if you include the debt of China’s state-run companies in the public debt load, it adds up. All in all, debt might cut GDP growth by as much as a percentage point.
And when the Chinese government has an explicit GDP growth target, and given the size of the Chinese economy, one percentage point of growth is a very big deal.
Worse, some Chinese companies can’t service their debt. As of April this year, China’s domestic bond market had already seen 22 defaults – as many as there were for all of last year. And two-thirds of these defaults were by state-owned firms.
That’s shaken investors who are realizing that state support is selective. And defaults will make lenders more cautious, once they realize that the government won’t always protect them. It will also result in higher interest rates for healthy and sick borrowers alike.
How will this end? One possible outcome is a repeat of what happened in the U.S. in 2007-2008. At that time the U.S. total debt-to-GDP ratio reached 250 percent. Borrowers started defaulting on their loans (especially mortgages) leading to a credit crisis. In the end, several banks failed, others were acquired or had to be bailed out by the government. It all led to a global economic crisis that is still hurting global economic growth.
Another possibility is that it will end with a whimper instead of a bang. China could lapse into a long period of slow growth, or stagnation, in part due to its debt load. This would be similar to what Japan has experienced for over two decades. Not surprisingly, Japan has one of the highest debt-to-GDP ratios in the world. Its government debt-to-GDP ratio at the end of 2015 was 246 percent.
The evolution of China’s stock markets might be a partial escape hatch. Right now, only about 5 percent of corporate funding is through equity markets – that is when companies sell new shares to investors. (Importantly, that isn’t debt – it’s selling ownership).
The other 95 percent of corporate funding is through debt financing. But if companies can start raising money in the equity market instead of the bond market, their debt levels will fall.
By definition, China’s debt burden isn’t a Black Swan – which is an event which has a very big impact but which is unexpected. If debt default in China is the second-greatest concern of global fund managers, it’s hardly unexpected. But that doesn’t mean it couldn’t do as much damage.
Kim Iskyan
