China's Debts Do Not Signal a Crash

Debts do not mean China is heading for a crash

That China has borrowed too much seems incontrovertible. Total debt to gross domestic product, a measure including public, consumer and corporate borrowing, has risen sharply to 230 per cent of GDP – much higher than before the global financial crisis, and comparable to levels that have led to severe problems elsewhere.

Those who are bearish on China seize on this ratio as evidence that the country is heading for a crash, a debt-driven hard landing. They highlight the industrial overcapacity and excess of built infrastructure as the inevitable consequences of such debt-fuelled growth. They remark on the rapid increase and opacity of shadow banking.

And they point to stresses in the interbank market, the recent default of a bond issued by a solar company and the weakness in the renminbi as warning signals of an imminent implosion.

China borrows a lot, but it also saves a lot

Yet, to jump to the conclusion that such a crash is inevitable is wrong. Equating China’s debt problem with what occurred in the US and Europe before the crisis ignores some important differences.

To start with, while China borrows a lot it also saves a lot. So it has largely been borrowing from itself. This is very different from being dependent on foreign creditors. Moreover, the increase in borrowing has largely been driven by companies rather than the government or consumers.

Yet at the same time, and rather paradoxically, China’s businesses have also been accumulating significant savings. With little pressure to pay dividends or improve returns, they are recycling their money through the banks and shadow banks to lend to other companies. It is not an efficient way to allocate resources but it is more an indicator of the deficiencies of the capital markets than of systemic over-indebtedness.

The leadership has recognised the problem

Furthermore, China has largely borrowed to fund investment. When you borrow to consume, as the US and Europe did before the crisis, you have little to show for it afterwards other than a slide in living standards when the party stops. When you borrow to invest, you may end up with some white elephants and overcapacity but you also gain some superb infrastructure, such as China’s high-speed rail network, and some world-class productive facilities.

Finally, China has recognised the problem. Not for Beijing the delusion of a ‘new economic paradigm’ that blinded so many policy makers and bankers in the west before the crisis.

The leadership knows it has a problem and it is determined to tackle it. At this month’s China Development Forum, a government-sponsored conference in Beijing attended by many of the country’s senior leaders, almost every session touched on the topics of over-leverage and overcapacity.

Radical overhaul of the financial system

Many of the warning signals cited by western analysts are deliberate or welcomed. The authorities want a tighter interbank market, applaud the greater discipline a bond default brings, and are determined to dispel the notion that the renminbi will always continue to appreciate.

So far Zhou Xiaochuan, governor of the People’s Bank of China, and his regulatory and government counterparts have proved remarkably sure-footed. In fact, China sees solving the debt problem as only one facet of a much more radical overhaul of the financial system, encompassing interest-rate liberalisation, development of capital markets, reform of local government finance and, ultimately, liberalisation of the capital account.

All these issues are interlinked. For example, the rise of shadow banking has as much to do with the search for yield as with demand for credit. With deposit rates capped, few bonds to invest in and dividend yields often derisory, savers are hungry for alternatives. Hence the extraordinary growth of internet savings vehicles such as Alibaba’s Yu’e Bao fund, which has attracted more than $80bn in deposits since its launch in June 2013.

Reducing debts gradually will be tricky

Side-stepping the deposit rate cap as well all the liquidity and capital regulations, such funds offer better rates than the banks – then they, in turn, lend their deposits on to the banks. This regulatory arbitrage, and the attendant moral hazard, is reminiscent of what happened with US money market funds before the crisis, and underscores the need for rapid progress on deposit rate liberalisation.

Gradually deleveraging without overly damping growth will be tricky. Transforming the way China’s entire financial system works is a Herculean endeavour.

There will be rough patches along the way, and plenty of scope for slips and stumbles – but so far Zhou Xiaochuan, governor of the People’s Bank of China, and his regulatory and government counterparts have proved remarkably sure-footed.

Underlying drivers of growth remain strong

It helps that, while the composition of growth in China is changing, the underlying drivers remain strong. Urbanisation continues apace. Domestic consumption, particularly of services, is increasing fast; and, since there is no overcapacity in services, there is plenty of scope for generating growth and jobs.

So, while there will be bumps and bruises along the way, China looks much more likely to navigate its way through these challenges than many western observers contend.

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