Too Much Debt Growth Since 2007: China, Japan and France

With a shift away from the ultra-low interest rate era, some debtors will face difficulties servicing debts.  Will this be a headwind to growth and also pose financial stability risks?   

Market Implications: In terms of financial stability, China’s ability to control debtors and creditors suggests that a major financial crisis can be avoided, though we remain concerned about weak banks.  For Japan, the alternative reality can be maintained provided that the BOJ does not abandon QE with yield curve control (given overseas accounts own little Japanese debt) and cause huge domestic financial instability.  France can likely weather the hangover from the 2009-21 debt party surge, but is vulnerable to any major policy mistake with overseas holders owning government debt equal to 50% of GDP.      

Figure 1: Change in Total Non-Financial Sector Debt/GDP Since Q1 2007 (%)  

Source: BIS (data to Q3 2022) 

End of Ultra-Low Rate Era and Debtors Problems

The lagged effect of higher official rates and bond yields has already caused two periods of financial instability in the shape of last September’s UK LDI crisis and March’s SVB receivership in the U.S.  With official rates and yields unlikely to return to 2009-21 levels in most DM countries, more problems will likely occur as decisions made in a different era will likely undermine certain investments and loans. We look at this from a big picture initially across DM and EM countries. 

Figure 1 shows the net change in total non-financial debt/GDP since Q1 2007 to Q3 2022, which covers government/household and firm debt levels.  The surge in China (153%) is well known in the wake of the 2008/09 super large stimulus in China, but Japan (112%) and France (118%) have also seen a surge as debt has been used to fuel economic growth.  In contrast, the U.S. has increased by a more modest 34% since Q1 2007, despite fears about too much debt in the U.S. system.  At a big picture macro level, U.S. household debt/GDP has fallen 22% since 2007 (due to deleveraging after the housing burst); corporate debt has risen by 13% of GDP and general government debt by 44% of GDP.  We do feel that the U.S. still has problems that have been identified by the Fed financial stability review in November (e.g. non-bank financial system here), which can cause problems.  Additionally, the shift in official interest rates and bond yields will undermine more borrowers in the coming years. However, the U.S. has not seen the large surge in total non-financial sector debt that occurred in the period up to 2007, so the scale of the problem will likely hurt rather than cause a sustained crisis.  

By way of comparison Figure 2 shows the change in total non-financial sector debt between Q4 1998 and Q4 1996, where Spain and Ireland saw the largest hangover before their property burst from 2007 onwards and the UK/U.S. suffered from poor lending decisions made before the global financial crisis.  

Figure 2: Change in Total Non-Financial Sector Debt/GDP Q4 1998-Q4 2006 (%)  

Source: BIS  

Looking further afield at other mid-sized DM countries (Figure 3), shows noticeable surges in Switzerland (76%), Canada (83%) and Sweden (83%) but more controlled increases since 2007 in Australia/Norway and New Zealand. All six countries have residential property markets that are under pressure from rising official and mortgage rates and this will likely translate into rising non-performing loans (NPLs).  Household/debt GDP ratios are elevated in all six countries except Norway and Sweden, but above 100% of GDP in Canada/Australia and Switzerland.  However, the breakdown of the BIS data shows that the surge since 2007 in Canada was across government/households and firms and in Switzerland and Sweden was largely from corporate debt increases.  We shall return to look at this group of countries in more detail in a separate article.    

Figure 3: Total Non-Financial Sector Debt/GDP Since Q1 2007 (%) 

Source: BIS  

A major surge in total non-financial sector debt is a concern, but it depends on the starting point and the composition.  In China’s case (Figure 4), the starting point was below India in 2007, but now, the total non-financial sector/debt GDP is above other BRICS and above the U.S. (257%) and EZ (259%).    

Figure 4: Total Non-Financial Sector Debt/GDP Since Q1 2007 (%) 

Source: BIS 

China has also seen a split surge across government/households and firms (Figure 5).  Firm debt/GDP at 163% of GDP is elevated by western standards.  We have argued that this high level of China’s debt is unlikely to expand at the rate that occurred since 2007 going forward and this will mean less debt and credit fuelled growth.  After the cyclical recovery in 2023-24, we see growth relapsing to below 5% and eventually to 3-4% (here).  Only moderate productivity growth and little population growth are other reasons behind our forecast.  The financial stability implications are different.  A large part of the corporate debt is either state owned enterprises (SOE) or local government financing vehicles (LFGVs).  In the worst case, SOE and LGFVs will likely be bailed out by local and central government.  For example, in a recent article (here) we noted that China’s government swapped LGFV debt for local and central government debt in 2015. Additionally, in an emergency, given that China’s debt is in Yuan and overwhelmingly owned by domestic players, the Chinese authorities can instruct creditors to extend debt to zombie borrowers as they did during the 2020 COVID crisis.  We do remain concerned that property developer debt will cause strains in rural banks (here), but the authorities will resolve this by takeovers rather than allowing failures of banks.  Even so, measures to support weak debtors is an economic drag on China economy, as it restricts new good quality lending in the coming years.        

Figure 5: Change in Total Non-Financial Sector Debt/GDP Since Q1 2007 (%)

Source: BIS  

Japan’s surge in debt has largely been due to the government since 2007, with little consequences due to the BOJ QE policy – especially since the step up to aggressive government bond buying in 2013.  This has meant that the credit/GDP gap has swung positive and is now higher than China/France now or the U.S. in the run up to the GFC (Figure 6).  Government debt normally tends to be longer average maturity, while the government can also fiscally dominate the central bank for a period of time.  Japan has lived in this alternative reality due to the generosity of the BOJ.  An end to QE with yield curve control would cause a jump in 10yr JGB yields back to the 1-2% range initially and cause a bite from the huge total non-financial sector debt/GDP at 416% of GDP.  Our central view is that the BOJ will likely only increase the 10yr yield cap from 0.50% to 0.75% in September/October and then defend the cap, which will curtail debt servicing costs to Japan’s households and firms – see Figure 7 for the controlled debt servicing costs in recent years.  This is driven by our view that inflation will fall through the course of this year.  If we are wrong and inflation were to settle at 2% consistently, then the BOJ would need to consider an exit strategy and that could really drive up debt servicing costs for all debtors.      

Figure 6: Credit Gap to GDP (%)

Source: BIS  

Figure 7: Household and Firms Debt Servicing/GDP (%)

Source: BIS  

France’s surge in debt/GDP to 340% (2nd highest behind Japan of the major countries we cover) has come across government/households and firms in the period since 2007 (Figure 5), which has been used to sustain economic growth in France.  Debt/GDP levels for Q3 2022 were 110%; 67% and 164% for the government/household and corporate sector respectively.  Corporate debt levels could have partially been boosted by the success of French multinationals, which means that debt is being sustained not just by French GDP but EZ and Global GDP.  The 2021 balance of payment data shows a EUR319bln increase in the value of French owned direct investment between 2011-21.  However, we will be watching this sub sector for problems, as the feedthrough of ECB official rates has yet to fully feed into loan rates.  Additionally, the debt servicing of the household and businesses sector is now higher than the U.S. was in 2007 (Figure 7) and suggests a vulnerability to overtightening from the ECB (here).  We would see it being difficult for French companies to increase leverage as they have done since 2007 and this will be a headwind to France’s medium to long term growth.  

Meanwhile, the French government’s ability to run a large gross debt is partially a reflection of confidence that the ECB would always rescue the core EZ countries and their market-friendly debt management.  However, the French government debt increase also reflects the ease of issuing in an ultra-low interest rate era that is unlikely to be repeated in the EZ in the coming years.  Additionally, unlike the BOJ, the ECB has not only stopped QE, but has started on QT.  One of the arguments about being relaxed about the French government debt/GDP profile was that the ECB owned debt equal to 35% of GDP.  The ECB QT for APP is slow, while higher coupons take a number of years to feedthrough to boost the French government debt servicing costs.  Even so, France’s net international investment position has deteriorated to 34% of GDP and gross liabilities at 375% of GDP are high for a large economy (EUR2.7trn of debt securities with French government paper in the minority at EUR1.1trn here). Unless a major mistake is made in France (e.g. government that abandons medium-term fiscal consolidation), we should not see a major financing crisis for the French government. Overall, higher interest rates, the existing outstanding debt and ECB QT means that the French government is unlikely to be able to fuel growth via extra debt issuance at the scale seen since 2007.  This is a 2nd headwind to French medium to long term growth.