Figure 1: China Debt/GDP: Household/Non-Financial Corporate and Total Non-Financial Sector (% of GDP)
Source: IMF, Continuum Economics
China Debt: Government Debt Bigger than First Blush
China’s success in achieving positive growth in 2020 and strong growth in 2021 has come at a cost of a renewed jump in total non-financial sector debt (Figure 1) by approximately 24% of GDP. Non-financial corporate debt and loans, plus government debt, have been the primary drivers as China seeks to navigate through a huge shock to the economy. Surging steel and cement production have helped a renewed building boom, while growth has also been helped by a surge in net exports. This old economy model of growth is temporary, and the 2021 National People’s Congress has shifted the focus to sustainable growth including deleveraging.
The good news is that China’s debt pile did not implode in 2020 in the face of the COVID-driven weakness for the economy, with some areas of resilience and quick policy support (monetary, fiscal, lending growth and flexibility). The debt problem is not for 2021, but over the multiyear period through the 2020s as China’s trend growth slows with a shrinking labor force and slowing productivity growth. China can achieve growth targets, but via either further debt-fueled growth or using credit less intensively to deliver economic growth.
How bad is China’s debt hangover? Some have focused on the buildup in debt prior to the bubble peaks in 1989 and 2008 in Japan and the U.S. At first blush, China private sector debt/GDP (ex-financial sector) has surged at a similar pace to Japan in the 1980s (Figure 2). Japan’s debt/GDP kept rising after the asset peak in 1989, both as nominal GDP slowed and borrowing kept rising to try and sustain the economy through the asset bust.
Figure 2: Japan (1980-94); U.S. (1994-2008); and China (2006-20) Private Sector Debt/GDP (ex-Financial Sector) (% of GDP at quarterly intervals)
Source: Continuum Economics, Datastream
China’s debt numbers require closer examination, however, as government debt is estimated to be 45% of GDP in 2020 on the narrower measure preferred by the Chinese authorities. The IMF reclassifies some of this corporate debt into an augmented government debt/GDP measure that is estimated at 109% in 2020 (Figure 3). The IMF measure includes local government financial vehicles (LGFV), government guided funds and special construction funds, as they come with an implicit government guarantee. This is not to say that LGFVs are as safe as the central government, as some are highly dependent on property levies and taxes. It is worth remembering that in 2013-14 LFGV debt equivalent to 22% of GDP was consolidated onto the central government balance sheet, and taking over debt of troubled government entities remains a clear policy option for the Chinese authorities in any future crisis.
Using IMF conventions (Figure 1), combined household and non-financial sector corporate debt in 2020 is estimated at 179% of GDP. This is still higher than the U.S. equivalent in 2008, while rising debt levels place a greater burden on weaker borrowers. China’s mortgage borrowers pay around 4.5%, while corporate borrowers pay 4-7% depending on the credit rating of the entity. This means that private sector debt servicing is taking a larger share of the economy. Chinese debt holders would also be vulnerable in the scenario of any substantive increase in interest rates — though this is unlikely with the output gap not set to close until 2024-25.
Figure 3: China Government and Augmented Government Debt (% of GDP)
It is worth noting, however, that the narrow non-financial sector corporate debt measure in Figure 1 includes some state-owned enterprise (SOE) debt. Moral suasion from the Chinese authorities has ensured that most SOE debt obtains favorable financing conditions and debt/loans are rolled over. However, the Chinese authorities have been cleaning up the industrial SOE sector over the past few decades, while some acutely weak SOEs are being allowed to fail to ensure that the SOE sector is not complacent about a free underwriting of debt by the Chinese authorities (e.g. Yongcheng coal and electricity). Remaining private sector corporate debt is split across the new economy that uses credit less intensively than the old economy, e.g. the property sector.
From a macroeconomic viewpoint, higher actual and quasi-government debt is also better than non-financial corporate debt that is separate across many entities. In the worst-case crisis scenario, it means that borrowers’ debt can be consolidated onto the government balance sheet and either maturity lengthened or some can be acquired and held via QE from the central bank — the latter is now semi-permanent practice in the G4 central banks.
Additionally, Chinese authorities have in the past acted aggressively to support creditors, with the bailout and restructuring of the big 4 banks in 1997-2005 including equity recapitalization; bad bank asset management companies; and providing banks with U.S. Treasuries as equity collateral. The current big 5 banks are regarded as well-capitalized, with the IMF in 2020 estimating big 5 common equity tier 1 at 12% versus 9% for the weaker joint-stock and small banks. These joint-stock and small banks have been involved in buoyant lending from 2008-18, before the official clean-up of the shadow banking sector became wider and started to restrain lending. In the scenario that this part of the banking system faced a systemic crisis, then the Chinese authorities could quickly use the tactics seen in the big 4 bailouts in 1998 to rescue the system and encourage takeover of weak but sustainable banks by healthy big 5 banks.
Overall, the Chinese authorities’ hybrid system will more slowly apply pressure on weaker borrowers and banks to ensure a modest deleveraging of riskier lending. This is not to say that modest deleveraging does not cause a headwind for the Chinese economy. It could make achieving 5-6% growth trickier in future years, given the declining labor force growth and slowing productivity. Switching from investment and export to a higher weight for consumption and services is not easy. Precautionary household savings remain high with the small safety net in China for health and unemployment, and this could restrict the growth in consumption among middle- to old-age households. The one key support for consumption is the under-40s that appear to have more Western-style consumption tastes in the larger cities. At times the Chinese authorities may have to revert to debt growth to fuel growth to meet their target meet their GDP target.
One long-term threat to weaker borrowers and creditors would be a property market bust in China. The effects are not just financial, but also economic, with some estimates that the wider footprint of the property sector is up to 24% of GDP. A property burst would hurt construction, jobs, mortgages and steel and cement production.
The Chinese property market has ups and downs and has so far avoided a bust. Residential property price inflation is currently reasonable (Figure 4). However, the cumulative surge in residential property prices has been massive and has pushed the national house price/income ratio up to 18. The lack of alternative assets, plus the importance of owning a home before marriage and the rural to urbanization trend, are fundamental reasons behind these elevated levels, but it is also due to speculation and a sense that property is a one-way bet. An alternative way of looking at this ratio is to invert the house price/income ratio to get a house price/income yield and compare versus 5yr government bond yields (Figure 5). The gap has narrowed consistently in the past 15 years, while the gap versus mortgage rates is narrowing given that they are around 150bps premium to 5yr government bonds. Additionally, more multiple home investors have been seen since 2015, but rent yields are now well below mortgage rates and this could mean negative returns if house prices do not rise by 2-4% per annum.
Figure 4: China New and Existing House Price Inflation for 70 Cities (%)
Source: Datastream, Continuum Economics
Figure 5: 5yr China Government Bond Yield and House Price/Income Yield (%)
Source: Datastream, Continuum Economics
Mortgages have also become more popular in China, but this does not appear to be a financial stability risk for homeowners if a moderate decline in property prices were seen. Firstly, the bulk of mortgages occur with large deposits, due to government macroprudential policies. Secondly, a larger proportion of debt is held by wealthy households according to the IMF Article IV report from 2019. This limits the financial impact on household borrowers in the scenario of a moderate decline in property prices, although the importance of housing in overall wealth could hurt consumption growth. Property developers and small to mid-sized banks’ overexposure to property lending are the weakest link. However, few signs exist of major national distress in the residential property market at the moment. For example, the time to sell completed housing (Figure 6) has risen to 2.2 and 1.6 years in Beijing and Shanghai, respectively, and rental yields are estimated to be 1-2% on new investment properties, but they are global cities with wide appeal. They need to be watched alongside tier 2 cities. Other cities’ time to sell completed stock is lower now than in 2020.
Figure 6: Years to Sell Completed Housing
Source: Datastream, Continuum Economics
Overall, we do not see any nationwide signs of major distress in the residential property sector, though problems do exist for certain cities and provide a local or regional property problem. From a macroeconomic standpoint, the Japan and U.S. property bubbles burst as high house price/income ratios were accompanied by excessive lending growth and a noticeable tightening of monetary policy. China’s hybrid system of interest rate pricing and moral suasion to stop/start lending argues against excessive tightening, while current macroprudential restraint constrains household borrowers in aggregate. Policy mistakes of acting improperly or too slowly could, however, turn a problem into a crisis. We are concerned about property developers and small to mid-sized banks, and any major national property reversal would cause a crisis in these segments.
The Scenario of a Property Developer Default
The current focus is on property developers, with the Chinese government signaling that it is looking for companies to sort their own finances out rather than receiving a strategic bailout like the strategically important Huarong Asset Management. Evergrande is one such company in focus, with CNY572bn of bond and bank borrowing, and a fire sale of assets occurring to avoid a default. In the scenario where Evergrande were to default, the Chinese financial system would be able to absorb the loss on default from recoverable assets. However, the onshore and offshore bond market for property developers would likely become more disruptive and could close for new primary issues for a time. It would likely cause wider adverse ripples in China’s financial markets. Additionally, the real economy effects would be adverse due to trade finance and other debtor default risks. The other channel is through reduced building and employment activity. This could trigger fiscal and monetary policy support in the worst case. It could also prompt a partial rescue of the company, with bond holders taking a haircut but bank borrowing being supported.