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Red ink rising

2016-03-08 12:20:00

China cannot escape the economic reckoning that a debt binge brings

Mar 5th 2016

HOW worrying are China s debts? They are certainly enormous. At the end of 2015

the country s total debt reached about 240% of GDP. Private debt, at 200% of

GDP, is only slightly lower than it was in Japan at the onset of its lost

decades, in 1991, and well above the level in America on the eve of the

financial crisis of 2007-08 (see chart). Sooner or later China will have to

reduce this pile of debt. History suggests that the process of deleveraging

will be painful, and not just for the Chinese.

Explosive growth in Chinese debt is a relatively recent phenomenon. Most of it

has accumulated since 2008, when the government began pumping credit through

the economy to keep it growing as the rest of the world slumped. Chinese

companies are responsible for most of the borrowing. The biggest debtors are

large state-owned enterprises (SOEs), which responded eagerly to the government

s nudge to spend.

State sponsors of error

The borrowing binge is still in full swing. In January banks extended $385

billion (3.5% of GDP) in new loans. On February 29th the People s Bank of China

spurred them on, reducing the amount of cash banks must keep in reserve and so

freeing another $100 billion for new lending. Signs of stress are multiplying.

The value of non-performing loans in China rose from 1.2% of GDP in December

2014 to 1.9% a year later. Many SOEs do not seem to be earning enough to

service their debts; instead, they are making up the difference by borrowing

yet more. At some point they will have to tighten their belts and start paying

down their debts, or banks will have to write them off at a loss with grim

consequences for growth in either case.

An IMF working paper published last year identified credit growth as the

single best predictor of financial instability . Yet China is not obviously

vulnerable to the two most common types of financial crisis. The first is the

external sort, like Asia s in 1997-98. In such cases, foreign lending sparks a

boom that eventually fizzles, prompting loans to dry up. Firms, unable to roll

over their debts, must cut spending to save money. As consumption and

investment slump, net exports rise, helping bring in the money needed to repay

foreign creditors. China does not fit this mould, however. More than 95% of its

debt is domestic. Capital controls, huge foreign-exchange reserves and a

current-account surplus help defend it from capital flight.

The other common form of crisis is a domestic balance-sheet recession, like the

ones that battered Japan in the early 1990s and America in 2008. In both cases,

dud loans swamped the banking system. Central banks then struggled to keep

demand growing while firms and households paid down their debts.

China s banks are certainly at risk from a rash of defaults. Markets now price

the big lenders at a discount of about 30% on their book value. Yet whereas

America s Congress agreed to recapitalise banks only in the face of imminent

collapse, the Chinese authorities will surely be more generous. The central

government s relatively low level of debt, at just over 40% of GDP, means it

has plenty of room to help the banks. Indeed, with the right policies, China

could survive a deleveraging without too much pain.

By borrowing and spending, firms boost demand; when paying down debts they

subtract from it. In the absence of new borrowing elsewhere in the economy,

growth will atrophy. China s government could try to compensate by borrowing

more itself to finance a fiscal stimulus. It might also use low interest rates

to encourage households to borrow more. (This week s cut in banks reserve

requirements seems designed to buoy China s property market.) But orchestrating

such a switch in growth engines is not easy. Firms and households might instead

be forced to deleverage simultaneously, exacerbating the pain. Household debt

in China is low but rising fast, raising the risk of a double crunch in future.

Moreover, China would have to ensure that existing bad debts are written down

and bankrupt SOEs shut a tall order politically. Reports this week claimed it

plans to lay off 5m workers, but big firms will resist a proper reckoning. The

bumbling response to the stockmarket and currency wobbles of the past year

calls into question the leadership s competence. The government may be able to

prevent an outright banking crisis, but the slump that usually accompanies a

deleveraging will be harder to avoid.

Foreign demand could perhaps help make up for the shortfall in domestic

spending. Deleveraging commonly occurs alongside large depreciations; as

spending in indebted economies falls the value of the currency declines, giving

exports a boost. That, in turn, helps put idle capacity to work and bolsters

the income of firms repaying loans. Big depreciations can also boost inflation,

helping keep the deleveraging economy out of a debt-deflation trap, in which

falling prices and incomes make debts with fixed values more expensive to

service. Countries that see big depreciations while deleveraging, as many Asian

ones did in 1997-98, typically suffer sharp but short downturns before

reverting to growth. In contrast, in countries that resist depreciation, as

Japan did in the 1990s and peripheral Europe has done recently, deleveraging is

slower and more painful.

China s government seems determined to prop up the yuan. But it may struggle to

do so while the economy deleverages. The grinding recovery that would imply has

political costs. And cutting rates to boost borrowing elsewhere in the economy

would place further downward pressure on the yuan, forcing the government

either to tighten capital controls yet more, run down its foreign-exchange

reserves or let the currency drop.

With a deft enough touch, China s debt bomb could fizzle. The rapid pace of

credit growth makes a benign outcome ever less likely, however. Given China s

size, a prolonged deleveraging would place a dangerous drag on global demand

growth, which the world s weakened economies would struggle to cope with. The

sooner China turns off the credit taps, the better.