China’s excessive debt: a bit of breathing room?

Moody’s decision in late May to downgrade China’s sovereign credit rating reanimated global concern about the country’s debt burden. According to the independent research house, Bank Credit Analyst, China’s corporate and household debt through 2016 topped out at over 220% of GDP, and according to Moody’s this figure is likely to rise over the next few years. Market observers are once again questioning whether or not these unsustainable debt levels, if coupled with a slowing economy and declining return on assets, will inevitably lead to a liquidity crisis, where Chinese households and corporations – many of them bloated state-owned enterprises (SOEs) – won’t have sufficient cash to both service the debt on their balance sheets and still generate growth. The remedy is clear: in order to avoid this fate, China needs to launch an aggressive deleveraging cycle that recognises losses on bad debt and reduces the overall debt balance.

The politics of deleveraging in China

Managing a deleveraging process is complicated work—and not just because of the financial legwork. Since the global financial crisis, deleveraging has become as much a political problem as an economic one. We saw this with Greece and the EU, as well as in the US with the 2008 housing crisis. In each case, the key political question policymakers had to deal with was: How to distribute losses equitably across all the stakeholders?

For China, this issue is particularly difficult. Losses need to be distributed across provincial governments, industries, companies, tycoons and, finally, common citizens. Each of these stakeholders has their own respective sphere of political influence. If the Central Government misallocates these losses, this could significantly impact China’s economic and political stability over the coming decades. Further, China’s political process is already consultative and often slow-moving; the deleveraging process introduces additional challenges.

The key to China managing the deleveraging process successfully, and avoiding a liquidity crisis, is for the Central Government to buy enough time to work through the complicated politics of distributing losses across the economy.

How the Chinese government is buying time

China’s Central Government has focused on three different techniques to delay the formal start of the deleveraging process and to manage internal competing political interests.

1. Imposing aggressive capital controls.
   Over the past 18 months, the Central Government has steadily tightened capital controls for corporations and households, in an effort to stem the estimated USD $1 trillion in illicit capital outflows over the past few years. Each instance of capital flight (when a domestic asset is sold and the proceeds are transferred overseas) results in 'mark to market' transaction that automatically assigns a loss to an economic stakeholder. Capital controls and capital transaction pre-approval mean that the government retains its central authority to distribute these losses and manage the deleveraging process.

   Data shows that recent capital restrictions have been quite effective – they have even contributed to a surprising increase in China’s foreign reserves, back above the critical USD $3 trillion level. Of course, this technique is not without risk. Capital controls are generally recognised as a blunt, crude tool that can contribute to onshore asset bubbles and distorted demand/foreign exchange valuations. Recognising these risks, China has spent the last few months easing some of the more aggressive controls on corporate cross-border flows.

2. Reducing the high-risk leverage in the banking and insurance sectors.
   In the wake of the financial crisis, China countered criticism of its state-controlled banking system by noting that Chinese institutions had avoided the worst behaviour of Western banks, which had used excessive amounts of leverage to increase their balance sheets at a growth rate multiples higher than GDP growth. Over the past three years, this retort has lost its effect: Chinese banks are behaving just like Western banks, dramatically increasing their balance sheets and leverage exposure.

   We can see evidence of this if we look at what portion of China’s monetary stimulus is actually being channelled into credit. Looking back in time, from January 2008 through 1H 2014, 97% of M2¹ was ‘credit forming.’ However, according to Deutsche Bank, from 2H 2014 through 1Q 2016, this figure dropped to an astounding 60%.

   What did the banks do with all that extra stimulus? For the most part they poured it into the off-balance sheet affiliated shadow banking sector and used it to buy interbank debt, dramatically increasing system leverage and overall risk. Deutsche Bank points out that this type of bank-driven, rapid leverage growth is one of the most common precursors to a financial system shock.

   If the Chinese government wants to buy time to sort out the political elements of deleveraging, it needs to quickly address this risk. To its credit, the Central Government has pushed back hard on this type of activity, introducing new regulations to curtail shadow banking exposure, shutting down products and using the People’s Bank of China's open market operations to reduce system liquidity. Regulator action has roiled the markets and increased volatility, but most market observers feel the clampdown was long overdue.

3. Driving growth by restructuring SOEs and increasing corporate profitability via reforms and ‘One Road One Belt’.
   The ultimate prescription for deleveraging success is GDP growth. It’s crucial, then, that China develops a profitability strategy for its SOE sector and policies to boost income for households. Thus far, China’s Central Government has focused its reform efforts on consolidating and restructuring SOEs in an effort to form a limited group of government-owned, large-scale, multi-national corporations that can generate enough cash flow to reduce debt.

   China intends for its ambitious One Road One Belt (OBOR) initiative to help Chinese SOEs to allocate excess capacity towards meeting increasing demand from international markets for basic materials, infrastructure, and capital goods. External critics question China’s ability to quickly execute a full-scale OBOR after extended delays, but even a partial implementation of the programme should contribute positively to corporate profitability—giving China enough time and space to grow out of its debt burden.

Looking forward to upcoming political meetings and continued deleveraging

Overall, the Chinese government’s careful management of the deleveraging process is proceeding apace. Of course, the three measures above all have advantages and disadvantages. If they are not successful in buying time to address the political aspects of deleveraging, China runs the risk of over-inflating asset bubbles, seriously curtailing medium-term economic growth, and negatively impacting social stability. Nevertheless, China appears to have created the space to address these political issues over the coming months.

It is too early to tell how successful these efforts will be, but the key Communist Party’s political meetings this autumn and the economic announcements in 4Q17 and 1Q18 should give us a clear indication of China’s deleveraging strategy. These actions are all positive indicators of China’s commitment to address its debt issue, and reduce the likelihood of a severe liquidity crisis in the country.

¹ M2 (a measure of the money supply that includes cash, checking deposits, savings deposits, and money market funds) https://www.businessinsider.com/china-gap-between-m2-and-credit-asian-financial-crisis-2016-5#HyhLikRKyfbB1jH7.99