China’s strong growth in Q1 helped debt dynamics but for how long?

After successfully containing the spread of the Covid-19 pandemic and achieving a sound growth rate in 2020, China has stepped into a new economic stage with a clearly higher debt ratio comparing to the pre-Covid period. The rapid growth of debt raised concerns in the market on the debt burden for years to come. However, the very rapid growth rate in Q1 2021 has helped to stabilize the increase in the debt-to-GDP ratio in that quarter, and in fact, reduced it to 269% in Q1 2021 from 272% at the end of 2020.

For the past quarter, a large part of the decline in the debt to GDP ratio is due to denominator effect - the cyclical rebound in Q1 with GDP growth above 18%. But if we counterfactually assume no GDP growth in Q1 2020, the debt-to-GDP ratio would have increased to 280% by Q1 2021. This explains why the sustainability of high growth in China is key to ensure reasonably good debt dynamics down the road.

Moving to the generation of debt, the decline in the debt ratio was very moderate for the household sector. In fact, the QoQ growth rate of household debt reached more than 4% during Q1 compared to only 1% in Q1 2020 and is even higher than prior to the pandemic (3.8% in Q1 2019). An important reason for the acceleration of household debt is the buoyant property market, which accounts for 64% of the total household borrowing. This seems to signal that containing the household debt is not an easy task as the property market is still key to support China’s economic growth even with the looming risks of high household debt burden.

The corporate sector (excluding local government financing vehicles, LGFV) witnessed a decline in its stock of debt to GDP, but there is still an acceleration in the accumulation of absolute debt level, as it grew 2.1% QoQ in Q1 2021 compared to -0.4% in H2 2020. In particular, banks have strengthened their medium to long term credit to Chinese corporates with 6.8% QoQ in Q1 2021. The latter is even higher than the QoQ growth rate in Q1 2020 (5.4%). On the other hand, the shadow banking component of corporate credit continued to decrease in line with the government’s efforts to rein in off-balance sheet financial risks.

The only component that experienced a deceleration in debt accumulation was the on-balance sheet debt of local governments. During Q1 2021, Chinese local governments’ QoQ debt growth rate went down to only 2.1% in Q1 compared to 7.1% in Q1 2020 and 6.7% in Q1 2019. The decline is particularly strong for the special bond issuance, partly reflecting the relatively slower pace of approval for the special government debt quota this year. In other words, the reduction in local government debt might not last long with a likely resumption in issuance in Q2. Furthermore, the slow growth in on-balance sheet debt may have been offset by a rise in local governments’ off-balance sheet debt. Our own estimate of LGFV debt as a proportion to GDP increased from 32.7% Q4 2020 to 34.1% in Q1 2021. In addition, the central government’s debt adjustment is relatively stable, with the debt stock’s QoQ growth rate in Q1 2021 lower than Q1 2020 but higher than Q1 2019.

In sum, China’s debt dynamics at the beginning of 2021 underscore the importance of economic growth to contain debt accumulation. But to maintain the momentum of economic growth, China will need to allow for a relatively stable credit environment, which implies more debt accumulation. Given that the growth of Chinese economy has already decelerated from the peak following the global financial crisis, we expect China’s overall debt to continue growing. As such, the priority of the Chinese government is likely to be directed to contain the risks associated with the debt dynamics. There is no silver bullet for this.