by Roberto Ippolito, Debt and private equity investor
The recent economic events in China (burst of the equity bubble, collapse of commodity prices, exchange rate devaluations) show how difficult it can be to combine a new growth model (domestic and consumption driven rather than export and investment led) with a more market oriented financial system, safeguarding the financial stability and the speed of growth of the economy.
The endeavour is complicated by the financial vulnerabilities that China faces whilst approaching the late stage of the credit cycle: disproportionate size of the shadow banking sector, excess banking exposure towards the real estate sector, banks with thinner capital cushions, increasing nonperforming loans, weakening of corporate earnings and deterioration of asset quality are all factors that make firms and financial institutions more exposed to financial stress, economic downturn, and capital outflows. A fragile financial sector (including the opaque and large nonbank financial system) implies a higher sensitivity to changes in financial conditions.
The major challenge facing the Chinese financial sector is to gradually and credibly unleash the power of market forces, foster a deeper equity market and reduce debt (also via the equity markets).
Debt represents the main source of concern: according to McKinsey*, China’s total debt to GDP more than doubled from 2000 to 2014, reaching 282% of GDP in Q2 2014 (such a ratio standing at 269% in the US and 258% in Germany).
Debt to GDP ratio in China, by sector
| 2000 | 2007 | 2014 | |
| Non financial institutions | 83 | 72 | 125 |
| Financial institutions | 7 | 24 | 65 |
| Government | 23 | 42 | 55 |
| Households | 8 | 20 | 37 |
| TOTAL | 121 | 158 | 282 |
Source: McKinsey
As shown by the table above, nearly half of Chinese debt is concentrated in non financial institutions. Shadow banking** in China has grown dramatically in the last decade and today represents nearly a third of loans outstanding to households, non-financial corporations, and governments. One of the main reasons of the boom of shadow banking lies in the imperfect calibration between central planning and market forces. The constraints and guidance imposed by the state to the banking sector (still dominated by large state-controlled banks) have become over the years so binding that business has flowed to shadow banks. Among these constraints, we cite caps on bank lending volumes, limit of bank loans to deposits of 75% and pressure to discourage lending to certain industries. As a result, non-banking channels (which have lower capital and liquidity requirements, are not subject to bank limits on loan or deposit rates and do not bear costly PBOC reserve requirements) have blossomed. The rapid growth of shadow banking has also been driven by the increasing demand for higher-yield investment products among Chinese retail investors, pushing financiers to invest in speculative real estate projects and other risky borrowers. China’s shadow banking system involves different sources of credit: entrusted loans (large companies make loans to other companies, arbitraging the spread between their low cost of funding and what they can charge smaller companies, with potential contagion risks), trust loans (marketed to high‐net‐worth investors, these vehicles have a quite flexible charter, offer returns of 10-15% and usually invest in private‐placement loans and securities), wealth management products (sold by banks to retail customers with minimum deposits of $8,000, have holding periods below one year but make loans with a duration of one to three years, creating maturity mismatch risk) and informal loans (financing companies, rural cooperatives, microcredit institutions, and Internet peer-to-peer lending, used by households and small businesses).
Financial institutions debt account for 65% of debt to GDP. China has relied on investment to drive growth in recent years: increase in investment has been financed significantly by bank credit. Across industries, most of the build up in leverage was
in the real estate and construction sector and, to a lesser extent, to securities firms. The real estate market is very important (up to 25% of GDP) to China’s economy and its value underpins the banking system. A correction in China’s real estate is under way and the risk to the Chinese economy stems from the impact on property developers and companies that operate in related sectors, such as steel and cement. More recently, flow started being reallocated - directly and indirectly - from a weaker property market to a buoyant stock market, increasing investor leverage in the form of margin financing. Notwithstanding the limited wealth effects, the recent collapse of the Chinese stock market has sent jitters related to the strength of the Chinese financial system: the systemic relevance of equities is in fact limited but the interconnectedness with the rest of the financial system has grown. The increase in short-term leverage by securities firms has strengthened the link between equity markets, banks, and short-term funding markets: consequently, securities firms could quickly transmit a liquidity shock to funding markets if they were unable to their meet debt obligations (stemming from customer defaults on margin loans).
Finally, government debt accounts for about 55% of debt to GDP. Although low by international standards, the concentration of government debt owed by local governments is concerning and potentially hampering the central government’s efforts to develop a municipal bond market. In November 2014, the rating agency S&P issued a report stating that as many as half of China’s provincial governments, if rated, would be below investment grade. The main risk of local government is related to the fact that most local borrowing in recent years has occurred through opaque special-purpose vehicles, a structure used to circumvent a 20-year ban on borrowing by provinces and cities, which lenders view as carrying an implicit government guarantee (even where no legal obligation exists); further these vehicles fund projects using public land as collateral.
Although debt is under constant monitoring by local and international authorities, the main concern over Chinese high level of debt is not whether China would be able to absorb financial shocks but over the effects of debt on the growth of the economy. China’s central government debt stood in fact at 32% to GDP in 2014 and therefore China has borrowing capacity to bail out the financial system if defaults increased dramatically. However, as also shown by recent research by Jorda-Schularick-Taylor*** on 17 countries over the past 140 years, what makes some bubbles more dangerous than others is credit. When fuelled by credit booms, asset (such as equity or real estate) price bubbles increase financial crisis risks and upon collapse they tend to be followed by deeper recessions and slower recoveries.
It is therefore reasonable to expect a decline of Chinese growth as excesses in real estate, credit, and investment continue to unwind and economic policies are geared towards reducing vulnerabilities rather than offsetting economic weakening. Negative spillovers on global trade and downward pressures on commodity prices can be envisaged.
* Mc Kinsey Global Institute (2015). “Debt and (not much) deleveraging.” McKinsey&Co.
** Estimates of the size of China’s shadow banking sector can vary greatly (from a minimum of 30-35% of GDP according to IMF and FSB) as a result of different definitions and statistics. See also: Elliott, Kroeber, Qiao (2015). “Shadow banking in China: A primer”. Economic Studies at Brookings, The Brookings Institution.
*** Jorda-Schularick-Taylor (2015). “Leveraged bubbles.” CEPR Discussion Paper No. DP10781.
