Blog Post

Why is China finding it hard to fight the markets?

Sitting on a pile of debt, China’s only way out is to deleverage: more pain now for sustainable growth later.

By: Date: August 31, 2015 Global Economics & Governance Tags & Topics

China’s market drama started in June this year with the collapse of the Shanghai stock exchange, followed by frantic interventions by the Chinese authorities. As if the estimated $200 billion already spent on propping up stock prices were not enough, China found itself in another battle with the market, defending the RMB against depreciation pressures after the PBoC devalued the RMB by nearly 2% on August 11. The cost of the foreign exchange intervention to keep the RMB stable is estimated at $200 billion.

This adds to existing pressures on China’s international reserves, which though still extensive, have been reduced by as much as $345 billion in the last year, notwithstanding China’s still large current account surplus and still positive net inflows of foreign direct investment (Graph 1). The fall in reserves is not so much due to foreign investors fleeing from China but, rather, capital flight from Chinese residents. Another –more positive reason – for the fall in reserves is that Chinese banks and corporations, which had borrowed large amounts from abroad in the expectation of an ever appreciating RMB, finally started to redeem part of their USD funding while increasing it onshore. While this is certainly good news in light of the recent RMB depreciation, the question remains as to how much USD debt Chinese banks and corporations still hold and, more generally, how leveraged they really are a time when the markets may become much less complacent, at least internationally.

Figure 1 – China’s Balance of Payments

China01

Public and corporate sector over-borrowing can be traced back to the huge stimulus package and lax monetary policies which Chinese economic authorities introduced during the global financial crisis in 2008-2009. A RMB 4 trillion investment plan focusing on infrastructure was deployed, but the real cost spiralled. The government also subsidized the development of several important industries and lowered mortgage rates to boost housing demand. At the same time, the PBoC substantially loosened monetary policy with interest rate cuts, reductions in reserve requirements and even very aggressive credit targets for banks.

According to the authorities’ initial plan, the funds needed for the stimulus package would come from three sources: central government, local governments, and banks, with costs shared relatively equally. However in practice, given their limited fiscal capacity, local governments had to turn to banks to meet their borrowing needs. Banks could not decline loan requests from central or local government because of government ownership and control over most banks. In the meantime, government subsidies for specific industries boosted credit demand as firms in these sectors sought to take advantage of policy support and expand their production capacity. Mini-stimulus packages have since become the new norm of China’s economic policy. When growth started to slow in 2012, the authorities responded by rolling out more infrastructure projects to revive the economy, which has blotted China’s consolidated deficits every year since 2008. Although no official statistics exist on this, our best estimate is 8-10% fiscal deficits with the corresponding increase in public debt every year (fig. 2).

Figure 2 – China’s augmented fiscal deficit as % of GDP

China02

All in all, China’s public debt today is above 53% of GDP, according to the National Audit. This may look small by international standards, especially in the developed world, but the rate of debt growth is unmatched elsewhere, and is even higher than Japan with its recurrently large fiscal deficits (fig. 3).

Figure 3.  Government debt in China and Japan

China03

On the corporate side, cheap money at home made it very – if not too – easy for companies to borrow. In fact, corporate debt has doubled as a percentage of GDP in the last 14 years. Beyond the stock of debt, its service is becoming an issue for corporations as the Chinese economy decelerates and their revenues are on the wane. Taking a very simple measure of stress in debt service, the ratio of EBITDA to interest expense has been below 1 for about one third of Chinese domestically-listed corporates, implying that their operating cash flow was insufficient to service their interest payments. This is especially the case for private ones (fig. 4).

Figure 4. Corporate debt stress ratios

China07

Source: Wind, CEIC and BBVA Research

Given that banks’ balance sheets have not been able to accommodate the borrowing from both the public and the private sector, a significant share of the corporate sector, especially smaller corporations, has increasingly used the shadow banking sector to meet their financing needs and circumvent tightening regulations on bank loans (Graph 5). This hardly regulated part of the financial sector now constitutes nearly 30% of GDP, with a good amount of inherent risk.

Figure 5 – Shadow banking has become an important source of financing

Source: CEIC and BBVA Research

China04

By the same token, the FED quantitative easing coupled with a cheap dollar and the expectation of continuous RMB appreciation made it even easier to borrow from overseas and, to a large extent, from international banks. In fact, the exposure of Chinese banks and corporates to dollar debt has ballooned in the recent years, only correcting very recently in anticipation of FED hikes and the recent RMB depreciation, as previously mentioned (Graph 6).

Figure 6

Source: BIS, Natixis

China05

Finally, even households have not been totally spared from the leveraging mania. This can be explained by the fact that they have been confronted with an ever more expensive housing market and, more recently, the possibility to hedge massively to invest in the stock market. All in all, China’s total debt was 284% of GDP a year ago and, given the still large fiscal deficits and the leverage-fed stock market bubble – it seems likely that it may have reached 300% of GDP today.

Figure 7

Source: Datastream, PBoC, Natixis

China06

Notwithstanding its massive size compared with other emerging economies, the fact that most of it is domestic has been the key argument for the Chinese government and many economists to downplay the risks. There are, however, at least two main reasons why we should worry about China’s debt. First of all, even domestic debt has to be paid if you want to avoid huge distributional effects. In particular, local government debt will need to be cleaned up at some point, which will worsen banks’ asset quality unless the current loan for debt swap program is extended massively, which then pass the burden on the central government. Second, and more importantly, excessively high debt is known to slow growth. The underlying reason is that every unit of new credit has a harder time in finding a productive project to invest in as those which were more productive have already been funded. In fact, as Graph 8 shows, in the past the Chinese economy needed much less credit for a single unit of investment than it needs now.

Figure 8

Source: datastream, PBoC, Natixis

China08

On this basis, it seems clear that China can no longer use the old recipes to stimulate its economy. This would only induce additional leveraging and China needs just the opposite. Deleveraging will be painful in the short term, as investment will have to come down even more than it has already. But then wasn’t rebalancing towards a consumption-based model what China really wanted and needed? I would advise the Chinese authorities to forget about more fiscal and monetary stimulus, and push towards deleveraging: better more pain now for more sustainable growth later.

 


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Blog Post

Silvia Merler

Tariffs and the American poor

What’s at stake: much has been said and debated — during the US election and beyond — about the distributional impact of free trade on the disadvantaged. But what would be the distributional impact of a new protectionism instead?

By: Silvia Merler Topic: Global Economics & Governance Date: January 23, 2017
Read about event More on this topic

Upcoming Event

Jan
24
12:30

The future of EU trade policy

We are happy to welcome the European Commissioner for Trade Cecilia Malmström to Bruegel on 24 January to talk about the future of the EU's trade policy.

Speakers: David Bremmer, Cecilia Malmström and André Sapir Topic: Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic

Upcoming Event

Feb
9
08:30

Financing the Belt and Road Initiative

The Belt and Road initiative, recently embarked on by China, aims to improve cross-border infrastructure in order to reduce transportation costs across a massive geographical area between China and Europe.

Speakers: Alicia García-Herrero, Mingxi Sun, Jianwei Xu and Alessandro Carano Topic: Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic More by this author

Blog Post

Guntram B. Wolff

Manufacturing in the US: Will Trump’s strategy repatriate highly-paid jobs?

Trump has set out a plan to repatriate highly-paid manufacturing jobs to the US. But the idea that manufacturing jobs are better paid than service roles is a myth. Moreover, labour markets are slow to shift between sectors. An aggressive trade policy may create some jobs in manufacturing but will not be a benefit to US citizens in general.

By: Guntram B. Wolff Topic: Global Economics & Governance Date: January 6, 2017
Read article More on this topic More by this author

Opinion

Nicolas Véron

Giving Asia its due in global financial regulation

With US inward turn, China should get a bigger role to bolster system

By: Nicolas Véron Topic: Finance & Financial Regulation Date: January 5, 2017
Read article More on this topic

Blog Post

dsc_0809
dsc_1000

The impact of Brexit on Northern Ireland: a first look

Following the proposal from the Scottish Government that Scotland remain in the Single Market, the differing “Brexpectations” of the UK’s four constituent countries are once again back in the news. Scotland is getting a lot of attention in the Brexit debate, but Northern Ireland is an equally interesting case.

By: Filippo Biondi and Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: December 22, 2016
Read article More on this topic

Blog Post

Alicia García-Herrero
DSC_0160

Is the UK’s role in the European supply chain at risk?

Will tge UK’s engagement in European supply chains be at risk once the UK exits the EU?

By: Alicia García-Herrero and Jianwei Xu Topic: European Macroeconomics & Governance Date: December 20, 2016
Read article More on this topic More by this author

Blog Post

Marek Dabrowski

Challenges to debt sustainability in advanced economies

The gross general government debt-to-GDP ratios in many advanced economies have reached the highest levels in peacetime history and continue to grow, putting into question sovereign solvency in these economies.

By: Marek Dabrowski Topic: European Macroeconomics & Governance Date: December 8, 2016
Read article More on this topic

Blog Post

Alicia García-Herrero
DSC_0160

UK-China agreement on trade in services is no substitute for a UK-EU deal

The UK government has high hopes that new trade deals with non-EU states will offer an economic boost after Brexit. But how likely is this to materialise? The authors show that a FTA with China is unlikely to offer much to the UK's prominent services sector. Strong links with the EU will remain vital.

By: Alicia García-Herrero and Jianwei Xu Topic: Global Economics & Governance Date: December 6, 2016
Read article More on this topic

Blog Post

Alicia García-Herrero
DSC_0160

Trump could give new impetus to EU-China relations

It is too early to say what the Trump administration’s trade policy will look like – but a total cut-off from Asian partners is unlikely. It would harm the US economy, and offer China even more scope to cement its position in Asia. Nevertheless, with TPP and TTIP both looking unlikely, the EU should move fast to build relationships with China and ASEAN countries.

By: Alicia García-Herrero and Jianwei Xu Topic: Global Economics & Governance Date: November 15, 2016
Read article More by this author

Blog Post

DSC_0794

Trump, NATO and European defence spending

US President-Elect Donald Trump made critical statements about low European defence spending during the election campaign - signaling an expectation that Europe should contribute more to the cost of its security. Indeed, most European NATO members have spending well below the 2% target that NATO membership entails. Reaching this target could cost the EU27 NATO members 96 billion USD per year.

By: Justine Feliu Topic: European Macroeconomics & Governance, Global Economics & Governance Date: November 15, 2016
Read article Download PDF More on this topic More by this author

Policy Contribution

pc_21_16_page_01

Are advanced economies at risk of falling into debt traps?

One of the consequences of the global financial crisis has been rapid growth in public debt in most advanced economies. This Policy Contribution assesses the size of public debt in advanced economies and considers the potential consequences of sovereign insolvency.

By: Marek Dabrowski Topic: European Macroeconomics & Governance Date: November 10, 2016
Load more posts