China’s total outstanding credit growth has stabilized around 11-12% over the last half-year or so. That has stabilized investment and broad growth for the time being. But, that pace of credit growth is higher than nominal GDP growth, pushing the country’s debt burden higher.
My estimate for China's total debt to GDP is around 240%*. That compares to the IMF’s 225%, McKinsey & Company’s 217%, and Goldman Sachs' 270%. Estimates vary, but China’s debt burden is large for an EM country. More importantly, that debt burden is still growing, and the possibility for deleveraging is a long way away due to some core structural reasons. Debt has been a drag on growth and will certainly result in an unfavorable outcome for some individual commercial banks. But, risk of a systemic collapse is lower than many headlines have implied over the years.
Here are five important things to note about China’s debt burden:
There are three primary reasons at the core of China’s rising debt burden:
First, the country’s savings rate is very high. According to the IMF, China’s savings rate is 46%, one of the highest in the world. Only Qatar has a higher savings rate. And it is growing nearly as fast as overall debt. Yuan-denominated bank deposits in May rose 11.5% from last year. China is awash in liquidity, which is also the main reason why it is so prone to inflating asset bubbles like housing, stocks, or commodities. China’s loan to deposit ratio is roughly 71%. Asia in general runs with a lower loan to deposit rate than much of the world as a result of high savings rates. Western Europe averages about 111%, and Latam has the highest average regional rate at over 114%.
Second, China’s massive savings is trapped in the country. The capital account is closed and managed closely by the PBOC. So, there are few options for diligent savers other than bank deposits, property, financially engineered products, or stocks. Most of the population opts for bank deposits, with property as the main non-bank investment destination.
China’s financial intermediation system is still bank loan-centric. Bank loans comprise 65% of total credit outstanding, and many other forms of credit, like wealth management products, originate with banks. Other forms of intermediation are growing rapidly. The corporate bond market, for example, is only 10% of outstanding credit, but growing at 28% a year. Banks are still at the center of China’s financial intermediation, and so is the massive debt that banks have extended, both wisely and unwisely.
Those core reasons will not change soon. So, the debt burden will continue to rise until Chinese consumers become more spend-thrift, the capital account is opened, and financial intermediation develops much further beyond bank originated debt. Until things change, those massive, trapped savings will be turned into massive credit flows via the bank-centric system.
China’s debt problem lies in the massive buildup of corporate debt. The government is relatively frugal by global standards.
Households hold debt equivalent to 39% of GDP. That compares to 79% in the US, 88% in Korea, and 89% for Malaysia, according to Trade Economics.
Debt as a % of GDP by Sector
But, non-financial corporate debt is roughly 140% of GDP. That is nearly twice as high as the 80% average among EM economies according to the Institute of International Finance. Much of that corporate debt was directed to state-owned and state-affiliated firms which have return on assets two to three times lower than private firms, according to the Peterson Institute. China has always had a problem with lending to inefficient state firms in order to stabilize employment. Add to that the massive Beijing mandated lending spree for the years following the financial crisis, and the country has been left with many unprofitable, inefficient firms adding to overcapacity, kept alive solely on borrowing from banks. Those zombie firms consume capital that would be better invested by competitive new economy firms.
NPLs continue to rise, and the actual NPL number is hard to determine. The official number for NPLs is 1.75% of total loans, up from 1.67% at the end of 2015, and well below the global average of 4%. NPLs rose this year to an 11 year high of 1.4 trillion yuan. But, China’s NPL calculations are different than Western bank “norms”. Chinese banks only need to recognize an NPL if they expect a loss, giving them greater leeway in categorizing delinquent loans. A better comparison would be to use the banks’ “special mention” loan category for delinquent loans that are not yet NPLs and combine them with the official NPL numbers. That calculation provides a better comparison to global peers. NPLs and “special mention” loans combined are roughly 4% of total loans, on par with global averages, but growing for 18 consecutive quarters. Pimco estimates that NPLs will top out around 6% of all bank loans.
The IMF estimates that Chinese banks have $1.3 trillion in “risky loans” - risky, but not NPLs - on the books. If all of those risky loans were to become NPLs, they would total 15% of all lending. At a 60% loss ratio, that means $760 billion of potential bank losses; large but manageable. That is equivalent to 1.9 years of the banking system’s pre-tax 2015 profits.
The debt problem does not pose a risk of systemic financial collapse, but will present problems for specific individual banks and financial institutions that have stretched risks and regulations quite far. Banking crises usually begin with liability problems. China’s bank liabilities are overwhelmingly dominated by sticky deposits, which are now part of Beijing’s recently created depositor's insurance program. The required reserve imposed on banks is 17%. And, roughly 95% of China’s debt is domestic, with minimal foreign currency debt. On top of that, debt has gone to fund assets and not consumption.
If the IMF loss estimates outlined above were realized in full, some individual banks would be vulnerable. Those losses would not be evenly spread across the sector, but instead disproportionately hurt banks that have stretched regulations and risks as far as legally possible. The large state-owned banks that face greater regulatory scrutiny, like ICBC and Bank of China, will fare much better with losses than smaller, free-wheeling private banks like Industrial Bank.
Steps are being taken to fix the debt problem, but not all of the right ones yet. Policymakers need to do two things to mitigate the country’s debt problems. First, they need to stop the flow of debt to inefficient, debt reliant, unprofitable zombie firms. Then, they need to facilitate the removal of bad debt from the books. In doing so, eventually an appropriate amount of credit will flow to competitive firms.
Beijing has launched a test program this year whereby the six largest banks can sell up to a total quota of 50 billion yuan of securitized NPLs to clean up balance sheets. The program has had questionable success so far. Plans are also in the works to convert loans to troubled state-owned firms into shareholdings through debt-to-equity swaps.
It is widely agreed by both bulls and bears that Beijing will only fix the massive corporate debt problem by cutting credit flow to debt-addicted, inefficient, unprofitable zombie firms. That has met with political resistance over the years. Cleaning up NPLs will not work if banks are creating more at a rapid pace. Beijing still has much work ahead.
*If you include financial firm debt, that number approaches 300% of GDP. But, that method double-counts debt. If a policy bank extends a loan to a commercial bank, and that commercial bank lends the money to a factory owner, that is effectively one loan, not two.