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 Topic: Global Economics & Governance

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.

Read article More by this author
 

Opinion

Why China should fear the EU's carbon border tax

Expect Beijing to soon start lobbying against the proposal.

By: Alicia García-Herrero Topic: Energy & Climate, Global Economics & Governance Date: July 26, 2021
Read about event More on this topic
 

Upcoming Event

Sep
2
11:15

Towards a new global trade regime: reform of the WTO

Bruegel Annual Meetings, Day 2 - the World Trade Organisation has been going through trying times, a phenomenon amplified by the pandemic. Why are we headed towards a new global trade regime? And what lies ahead for the WTO?

Speakers: Ngozi Okonjo-Iweala and Guntram B. Wolff Topic: Global Economics & Governance Location: Palais des Academies, Rue Ducale 1
Read about event More on this topic
 

Upcoming Event

Sep
3
09:00

The role of the EU's trade strategy for an inclusive and sustainable recovery

Bruegel Annual Meetings, Day 3 - We are delighted to welcome Valdis Dombrovskis, Executive Vice President of the European Commission for An Economy that Works for People to talk about Europe's trade strategy.

Speakers: Valdis Dombrovskis, Alicia García-Herrero and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Palais des Academies, Rue Ducale 1
Read article More on this topic
 

Blog Post

A world divided: global vaccine trade and production

COVID-19 has reinforced traditional vaccine production patterns, but the global vaccine trade has changed considerably.

By: Lionel Guetta-Jeanrenaud, Niclas Poitiers and Reinhilde Veugelers Topic: Global Economics & Governance Date: July 20, 2021
Read article More by this author
 

Blog Post

The European Union’s carbon border mechanism and the WTO

To avoid any backlash, the European Union should work with other World Trade Organisation members to define basic principles of carbon border adjustment mechanisms.

By: André Sapir Topic: Energy & Climate, Global Economics & Governance Date: July 19, 2021
Read article More on this topic More by this author
 

Opinion

Could the RMB dislodge the dollar as a reserve currency?

The dollar remains the world’s largest reserve currency, but it is facing both domestic and external risks.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: July 14, 2021
Read article More on this topic More by this author
 

Podcast

Podcast

What should public spending look like?

What should we do about the increase in public spending due to COVID-19? Bruegel Director Guntram Wolff and Former Deputy Secretary-General of OECD Ludger Schuknecht discuss.

By: The Sound of Economics Topic: Global Economics & Governance Date: July 14, 2021
Read about event More on this topic
 

Past Event

Past Event

Strengthening the weak links: future of supply chains

What new supply chains trends will we see in the post-pandemic era?

Speakers: Ebru Özdemir, André Sapir and Guntram B. Wolff Topic: Global Economics & Governance Date: July 7, 2021
Read article More on this topic More by this author
 

Podcast

Podcast

CCP's 100th Anniversary: Reflecting and looking forward

As the Chinese Communist Party celebrates its 100th anniversary, we looked into the past, future and present of the country's economic development.

By: The Sound of Economics Topic: Global Economics & Governance Date: July 7, 2021
Read article Download PDF More on this topic
 

Policy Contribution

Commercialisation contracts: European support for low-carbon technology deployment

To cut the cost of decarbonisation significantly, the best solution would be to provide investors with a predictable carbon price that corresponds to the envisaged decarbonisation pathway.

By: Ben McWilliams and Georg Zachmann Topic: Energy & Climate Date: July 1, 2021
Read article More on this topic More by this author
 

Podcast

Podcast

Avoiding a requiem for the WTO

The WTO has been 'missing in action': how can we restore the organisation's role as a global forum for cooperation on trade?

By: The Sound of Economics Topic: Global Economics & Governance Date: June 16, 2021
Read article More on this topic More by this author
 

Podcast

Podcast

Challenges and growth of China's private sector

Is the dynamic role of the private sector in China under threat by its economic model and the United States?

By: The Sound of Economics Topic: Global Economics & Governance Date: June 9, 2021
Load more posts