China has a sizable, well-documented debt burden. It has led to growth headwinds for sure, as debt-burdened non-financial corporates have had to divert resources to paying and rolling debt. China's debt problem lies squarely with non-financial corporations, comprising 125% of GDP, as seen below. Households, local governments, and the central government have debt burdens that are relatively low by global comparisons.
Debt as a % of GDP by Source
China's debt is a persistent topic that is often dominated by dire warnings. But, if we take a step back and answer two questions, we can see that China's debt burden requires much greater monitoring of individual firms and sectors than in the past, but is not a source of alarm for the whole financial system and economy.
1) How does China's debt and level of investment compare to global peers?
To answer this I will use two charts. The first is a comparison of total debt (excluding financial) as a percent of GDP from the McKinsey Global Institute 2015 report on global debt (page 4) vs. per capita GDP. This number includes non-financial corporate, household, and government debt; everything but financial intermediaries. Including financial debt would introduce double counting. I excluded the country names to make a point. I will add them back in a later blog. Looking at this chart it may be difficult to pick out China. China's real economy debt level given the country's level of development does not appear to be an significant outlier.
The next chart shows capital stock per worker vs. per capita GDP. If China had been borrowing in order to fuel over-investment, then capital stock measures would show China as an outlier with more capital stock than it needs for the country's level of development. If it is not an outlier, then China has invested an appropriate amount for its level of development. Again, without labels it is difficult to say China's investment in the past has made it significantly different from global peers. So, debt levels to the real economy and the country's investments to date don't stand out as alarming vs. global comparisons.
Including the debt from financial intermediaries adds double counting to the debt to GDP calculation, and also makes it difficult for comparison across highly varied financial systems. But, here is the chart with debt to GDP including financial intermediaries.
In my opinion, China's debt load and investment stock does not appear to deviate significantly from global peers for its level of development, though that is obviously not a widely held view. The risk of a system-wide crisis is low. China's high debt load is primarily shouldered by indebted corporations that are struggling to operate and invest while diverting resources to pay that debt.
Here are the charts with country labels: Charts With Labels.
2) China's non-financial corporate firms have a debt burden of 125% of GDP. What sectors and firms are most at risk?
According to economists at the Hong Kong Institute for Monetary Researchers and the IMF, China's corporate sector does not appear to be over-levered in the aggregate. But, certain sectors and ownership structures have worryingly high debt burdens.
SOEs, for example, have significantly higher debt ratios than private firms. And, debt ratios at SOEs have increased, while private firms have de-levered over the last few years. Property companies in particular have a significantly high debt burden. McKinsey estimates that 45% of all non-financial corporate debt is directly or indirectly related to real estate.
It is important to note that mortgage debt in China is extremely low vs. global peers. Homeowner debt is not an problem (see chart at the top), but real estate developer debt is a risk.
Sectors with worryingly high debt burdens: Real estate, industrials (particularly SOEs and sectors with overcapacity), utilities, and materials.
Sectors with low debt ratios: Health care, IT, energy, and consumer.
Expect more defaults and view them as good for the economy.
This year 2 Chinese firms have defaulted on USD denominated debt. A coal importer missed a 13 million dollar payment in May on its 309 million dollars of debt. Kaisa, a homebuilding firm, missed a 23 million dollar payment in January. These were two small non-systemically important firms in some of the weakest and most indebted industries. There will be more defaults and firm failures to come, in a break from past implicit policies of bailing out all weak firms in one way or another.
Defaults and firm failures will instill discipline in the markets, and help to force structural changes. defaults will also help with reducing the country's overall debt burden. Credit is still growing faster than nominal GDP, so defaults are one of the few ways to reduce the overall debt burden on the economy. Of course, none of these will take place unless Beijing is indeed ready to let firms fail. Most signs point to yes.
Beijing has been preparing for potential financial system turmoil for years, setting the stage for defaults.
- The PBOC has created new lending facilities to help banks cope with turmoil.
- Deposit insurance was rolled out in May for 99.6% of all bank depositors.
- This year Beijing began a process for local governments to swap shadowy high interest debt (much of which is on the books of banks) with more transparent bonds. This plan has the potential to significantly reduce local government debt risks to banks.
- Banks have 18.5% of deposits in reserves.
- Most debt is held domestically (90%), and a significant amount of it between state-owned firms and state-owned banks.
- The central government has a very low debt burden (22% of GDP) and vast resources (potentially 350% of GDP, see chart on the right).
- Beijing firmly controls the central bank, much of the traditional media, nearly half of the banking system, and the judiciary, and can therefore pick and choose which firms to bail out and which firms to let fail. And it seems that there is now a willingness to let firms fail.
Beijing will use its resources to evaluate failing companies on a case-by-case basis, bailing out systemically important firms (or firms that are important to policymakers), and letting others fail. So, beware of small unimportant firms in weak indebted industries. Beijing may use their failures to clean house.
Expect more corporate defaults by non-systemically important firms going forward without significant risk to the financial system as a whole, and view most of those defaults as a good thing for structural change in China. More scrutiny than any time in the past must be employed when assessing Chinese corporations. Risk is growing in some industries, and many firms are doomed.