When credit is due

Is China’s debt-driven growth model living on borrowed time?

Picture illustration of Chinese 100 yuan banknotes

Closing ranks: negative talk about the economy is being discouraged

Even a broken clock is correct twice a day. And in the same way, an analyst can stumble on the right prediction if the same call is made year after year.

Step forward Gordon Chang. The American lawyer and columnist is best known for The Coming Collapse of China, published in 2001. At the time the US banks were snapping up strategic stakes in Chinese lenders. Chang took a dim view, arguing that new competition from foreign companies following China’s entry into the World Trade Organisation would drive state firms out of businesses, forcing them to default on bank loans and wrecking confidence in the Chinese financial system. The ensuing social chaos would see the Communist Party implode, he predicted.

Since then China’s economy has grown more than eight-fold, becoming the world’s second largest (and surpassing the United States on a purchasing power parity basis). Yet Chang has stuck to his guns. At a financial conference last week in Singapore, he warned again that doomsday could be near. His rationale: the Chinese have been “creating debt probably four times more than they are creating nominal GDP”, the Straits Times reports.

Last week the Financial Times estimated that China’s total debt had climbed to Rmb163 trillion ($25 trillion) by the end of March. Much of the recent surge in lending is a means to support flagging GDP growth. And while the sheer size of the debt burden is worrying enough, the FT says, the pace at which it is being accumulated looks even more alarming. China’s debt now equates to 237% of its economy, compared to 148% at the end of 2007.

Other organisations have made similar assessments on the scale of the debt. McKinsey Global Institute has estimated the debt-to-GDP ratio at 282%, for instance, while the Bank for International Settlements (BIS) puts the ratio at 249%.

To be fair, this is comparable to levels in the US (244%) and the Eurozone (257%), according to the BIS, whose calculations rely on data from the People’s Bank of China. But the ratio is much higher than other developing economies such as India (128%) and Brazil (146%).

How might the situation play out? “At one end of the spectrum is acute financial crisis – a ‘Lehman moment’ reminiscent of the US in 2008,” the FT notes. “Other economists predict a chronic, Japan-style malaise in which growth slows for years or even decades.”

One risk is a run on the banks as depositors panic about the prospects of a meltdown. So it’s worth looking at the country’s creditors – and especially the amount of debt held by foreign entities more prone to capital flight.

According to data from the Chinese central bank, outstanding foreign debt reached $1.53 trillion last September. This puts China’s foreign liabilities at 16% of its economy. In comparison, the foreign debt-to-GDP ratio of Brazil is 30% and that of Greece is close to 250%. (Moreover, nearly half of Chinese debt held overseas is denominated in renminbi, which means that the central bank could always print money to repay it, aka the Federal Reserve’s quantitative easing programme.)

“Almost all of China’s debts are held domestically. China won’t be affected by changes in the foreign capital market,” the state broadcaster CCTV suggested in response to a report by an international bank that the debt-to-GDP ratio had breached 250%. “The probability of a Chinese debt crisis is very low”.

The governor of the PBoC Zhou Xiaochuan addressed the same question during a press conference in February. “The Chinese government including the central bank has been highly concerned and we have carefully measured ourselves against our international peers,” he said. “Our debt-to-GDP ratio is relatively high and still growing, so we should be very alert. But is there a ceiling that, once breached, would mean trouble? We haven’t discovered any patterns to follow, after some painstaking research.”

Zhou went on to defend the speed at which debt has been growing. “China started from a very low base in the 1970s. Now there are a lot of opportunities in China for both entrepreneurs and investors but not all of them are financially well-off. What to do then? They have to borrow money… When our corporations and individuals have accumulated a certain level of affluence the leverage will decrease,” he added.

How about the huge liabilities on the books of local governments and state firms? Investors have been rattled by a slew of missed repayments and near-defaults in recent months (see WiC322). Tellingly, the yields on five-year government bonds had risen from 2.47% at the beginning of the month to 2.8% last week, the biggest one-month move since November 2013, the FT notes.

Caixin Weekly put a more positive spin on the bond market pullback, seeing it as a result of local governments coming under pressure to sort out their tangled finances. This process is long overdue, the magazine reports. The central government is also said to be considering plans for banks to swap as much as Rmb1 trillion of bad debt for equity in the companies concerned. The programme would probably involve China’s ‘bad banks’ (asset management companies, or AMCs, that take ownership of soured assets). For example, until last week China City Construction (CCC), an infrastructure builder, was wholly owned by a research institute under the housing ministry. CCC’s debt had grown by two-thirds over the past two years to Rmb42 billion (as of the end of September). Amid concerns that it was about to default on its bonds, CCC’s Hong Kong-listed unit said that a consortium comprising China Great Wall Asset Management (one of the leading AMCs) and three state banks had acquired a 99% stake in CCC on undisclosed terms.

This kind of deal turns banks into shareholders rather than creditors. But it will do little to alter the fundamentals at many struggling state firms. Critics complain that it simply keeps the worst “zombies” alive.

Li Jiange, once an aide to former Premier Zhu Rongji, offered a similar warning last month in the Tsinghua Financial Review. Many of the swaps would fail if the state firms did not improve their governance and business operations, he predicted. “For creditor banks, changing debt into equity is the last resort … It takes great effort for any debt-to-equity swap programme to show real effects. It’s bitter medicine to take.”

The FT also had doubts. “Delaying the inevitable means more pain at a later date,” it warned. “If you owe your banker a thousand bucks you are a debtor, but if you owe him a million you are his partner… China’s debt-for-equity swaps are a mess.”

This kind of critical view isn’t welcomed by the Chinese authorities, it seems, after the Wall Street Journal reported this week that local commentators are being warned to limit their public remarks about the economy.

“At high-level meetings over the past few months in the walled Zhongnanhai compound where the leaders work, some senior officials called for quashing any criticism that might encourage foreigners to ‘short China’ or bet against the prospects for growth,” the newspaper claimed, citing officials with knowledge of the discussions.

“The stepped-up censorship, many inside and outside the ruling Communist Party say, represents an effort by China’s leadership to quell growing concerns about the country’s economic prospects as it experiences a prolonged slowdown in growth.”

Keeping track: When we first reported on CCC’s sudden privatisation, investors were spooked as they’d counted on SOEs like CCC not being allowed to go under.

CCC tried a new tactic last week to restore its creditworthiness. Responding to market jitters, the company sent a letter to the People’s Bank of China asking for help.

In one of its most telling paragraphs the letter stated: “Our group is charged with a special mission (due to discipline reasons it’s not convenient to elaborate) and has continuously received a high degree of trust from the Party and the country… For this reason we absolutely cannot collapse”.

A photo of the missive has been widely forwarded among the financial community. The company clearly hopes to persuade its creditors that its unspecified “special mission” will keep its debt backstopped by the state, no matter what.

We’ll keep you posted.

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