Chinese Corporate Debt: A bubble ready to burst?
Report by John Graham, CSFI Intern
John Graham holds a Master’s degree in International Relations from the Hopkins-Nanjing Centre in China, where he studied from 2014 to 2016. He earned a commendation for an outstanding MA thesis on North Korea’s cyberwarfare programme. John learnt Mandarin while studying for his first degree, in political science, at Bard College, New York state. Most recently he was an intern at the Centre for the Study of Financial Innovation, where – among other things – he worked on this paper.
The Chinese economy is increasingly being weighed down by bloated and heavily subsidised State-Owned Enterprises (SOEs), with their high levels of debt. It is well known that the state sector is in dire need of downsizing and reform; it is also not news that the sector is being kept afloat by generous amounts of cheap credit from state-owned banks. What is not known is when this extraordinary boom will turn to bust, what form the bust will take, or even if there will be a dramatic crisis.
According to the Bank for International Settlements, which gets its data from national governments, total credit in the Chinese economy has already exceeded 200% of GDP and is still growing. The country’s debt problem is unique in two respects: firstly, foreign creditors and investors have minimal exposure; secondly, it is unfolding within an economy still largely controlled by the state.
The first point means that international ripple effects from a crisis could be minimal, though confidence in China as an investment destination would be dealt a blow. The second point is more important as it confounds attempts to predict how a debt crisis might unfold. A scenario in which a government – through direct ownership of most of the financial system – is heavily indebted to itself is unprecedented for a modern economy.
This paper will outline the state of Chinese SOEs and the state-owned banks that have extended enormous amounts of credit to them. It will also explore how the Chinese Communist Party (CCP) could resolve the unsustainable corporate debt burden. It draws on data from the People’s Bank of China (PBOC), the National Bureau of Statistics, and the Bank for International Settlements, as well as Chinese state-run media sources. State-run media – particularly the official party newspaper, the People’s Daily – is an important information source given that it reflects official government policy and can thus be used to gauge the government’s commitment to economic reform. All translations from Chinese language sources are the author’s own.
Western analysts are sometimes reluctant to trust Chinese economic data due to concerns over their accuracy and reliability. State media regularly trumpet the latest growth and employment figures to burnish the economic credentials of the CCP, leading to suspicions that such data is inflated, or even fabricated. A cottage industry has sprung up dedicated to creating supposedly more reliable indices for China’s growth and economic health . One of these is the famous ‘Li Keqiang Index’, named after then Governor of Liaoning Province – now Chinese Premier – Li Keqiang who, according to WikiLeaks, joked to the US ambassador that Chinese GDP data was ‘for reference only’. Li, a trained economist, preferred to keep track of freight haulage, credit growth and electricity consumption as more reliable indicators of economic activity .
Nonetheless, no one has more of an incentive to ensure reliable data collection than the Chinese government itself. During the man-made famine of the Great Leap Forward, the central government was regularly receiving ever-more fantastic reports of, among other things, record-breaking wheat production. In fact, much of the harvest had been left to rot in the fields since most farmers had been conscripted to man the ‘backyard furnaces’ in a drive to boost Chinese steel production . It is impossible to formulate meaningful policies on the basis of bogus data, and it is difficult to believe that the CCP did not learn from this experience.
However, there remains the possibility that reliable data available to the CCP is massaged for foreign consumption. This might be done to downplay risks to the Chinese economy in the eyes of the world. The problem is that data derived from the Bank for International Settlements – which is itself derived from data provided by central banks – does not provide a particularly rosy picture. If this data has been altered to minimise the warning signs, the situation could indeed be more serious.
Another problem is the availability of statistics, with certain data being classed, arbitrarily, as a ‘state secret’ or simply not made public. An example of the former is the exact composition of China’s foreign exchange reserves; an example of the latter is the balance sheets of many SOEs, which are not obliged to publish their financial positions.
Transitioning to the ‘New Normal’
Although all economies prize GDP growth, China is one of the few that sets actual growth targets for itself, a holdover from the Maoist era when performance targets could make or break an official’s career, thus incentivising officials to inflate crop yields and production figures far beyond what was possible. In 2015, when China’s GDP growth officially dropped below 7% per year for the first time, state media presented it as a ‘new normal’ for the Chinese economy, signalling its transition to middle-income status. It was around this time that state media began to talk about the middle-income trap and the need for ‘supply-side structural reform’ to avoid it, a veiled reference to the need for reform of the state sector .
The Chinese economy – and any discussion of it – is inextricably linked to the political system. State-owned industries, particularly in the extractive and manufacturing sectors, enjoy preferential access to credit from state-owned banks – a state of affairs that factions within the CCP wish to maintain. This is evident when state media publish official editorials attacking the idea that “the state advances while the people recede” , thereby denying that SOEs are vested interests at all, let alone a drain on the wider economy .
SOEs on Life Support
As of 2015, manufacturing industries, which are heavily dominated by the state, accounted for 40% of China’s GDP. Steel, mining, oil, construction and power generation make up the bulk of the state-owned sector. Writing at Project Syndicate, economist Yao Yang notes that SOEs receive over half of all credit extended by state-owned banks despite accounting for only a third of all industrial output . It is unclear just how uncommercial the credit from state-owned banks is, however. The Economist magazine notes that the very fact of state support dramatically improves SOEs’ credit ratings, pushing down their borrowing costs to an average annual interest rate of 5% in China’s onshore bond market, instead of 10% for equivalent private firms. Applying the same measure to the Hong Kong bond market, SOEs would have to pay 3.5% average annual rates without state support, instead they pay 2% .
Now that China is close to exhausting a growth model built on exporting cheap manufactured goods, the focus of economic policy has shifted towards reliance on domestic consumption, in line with other advanced economies. China had already neared the limits of export-driven growth when its was hit by the 2008 recession, the impact of which was only mitigated by an unprecedented expansion in cheap credit.
As figure 1 shows, RMB-denominated loan growth has been consistently positive, but it saw a massive 35% spike in 2009-10. This was enough to tide over the increasingly inefficient state-owned manufacturing sector. However, it also caused massive overcapacity in key industries – most notably steel, but also in other heavy manufacturing and extractive industries such as shipbuilding and coal .
Steel is an excellent example of credit-fuelled overcapacity. This has led to a dispute at the World Trade Organisation over whether China has actually become a ‘market economy’. The definition is an economy in which market forces, rather than government intervention, are the primary forces at work. China craves market economy status in part for the international recognition it would bring, but mainly because it would make it much more difficult for other countries to impose anti-dumping tariffs on its exports. For a non-market economy, countries can use their own criteria to decide whether to impose tariffs, whereas a market economy must be given the benefit of the doubt .
The dispute over steel centres on the enormous amounts of credit – which some argue are de-facto subsidies – that have kept China’s SOEs afloat despite haemorrhaging cash amid punishingly low prices, caused in large part by overproduction. Figure 2 shows how Chinese steel production kept climbing throughout the global downturn from 2008 – in contrast to other countries’ production – before finally declining in 2015. This steel glut would not have been possible without generous loans, and it has resulted in punitive tariffs being imposed on Chinese steel by the United States and the European Union .
Other manufacturing and extractive industries also suffered in the wake of the crisis. Figure 3 shows price indices for mining products, coal, oil and electricity, and an overall price index. From mid-2012 to 2014, prices were stagnant or slightly negative, but the sharp drop in 2014-16 indicates another intense cyclical downturn.
Massive overcapacity, coupled with weak demand at home and abroad, hit the profits of SOEs, with state support keeping them operating under conditions that would have bankrupted a private company.
The Big Four
The four largest state-owned banks in China are Bank of China, Agricultural Bank of China, China Construction Bank and Industrial and Commercial Bank of China. As figure 4 shows, even though their share of the financial sector had been shrinking, these four account for a significant proportion of total loans extended domestically. Being state-owned, they are de-facto ‘policy banks’, acting according to government policy – which includes extending credit on favourable terms to SOEs.
Figure 4 does not include loans made by ‘shadow’ banks – a topic addressed below. Leaving aside that segment’s role, the data probably reflect a trend for smaller regional banks to pick up the slack of the Big Four to sustain credit growth. If true, this would be significant since smaller state-owned banks are, by their nature, less politically favoured and less systemically important to the financial system, meaning they are less likely to be bailed out in the event of a financial crisis.
The Big Four appear to be financially healthy, with Bank of China, for example, enjoying net profits of $22bn in the third quarter of 2016 . Regardless of that, in the event of a financial crisis – such as a wave of major SOEs going insolvent – these four banks are essentially too big fail, not just because of their size but because they are the most visible symbols of the party-state. The failure of a major state-owned bank would be far more politically damaging than the failure of a private bank or a shadow bank.
Shadow banking, by definition, exists outside the officially regulated banking system and develops in order to circumvent restrictions imposed by the government and central bank. Shadow banks are, therefore, not subject to the PBOC’s liquidity and reserve requirements, making them an appealing source of funds for businesses – and even local governments – that find it difficult to get financing elsewhere.
Due to the nature of shadow banking, the exact size of the sector is difficult to determine. Nonetheless, it has been estimated that at the end of 2014, the sector in China was equivalent to 40% of GDP and had grown to 78% by the beginning of 2016. These estimates are based on PBOC data regarding ‘Total Social Financing’, namely financing provided by non-banking financial institutions. Being based on official data, such figures probably underestimate the size of shadow banking, which is kept off official balance sheets .
Complicating the picture further is the fact that licensed banks are themselves often involved in shadow banking. As of 2015, banks were required to keep 20% of deposits in reserve at the PBOC, earning extremely low interest rates. Two thirds of shadow banking activity involves a legitimate bank soliciting the participation of a non-bank to offer loans disguised as other types of transaction. This allows the bank to circumvent PBOC regulatory requirements and charge considerably higher interest rates .
Despite the opaque and inherently risky nature of shadow banking, a systemic crisis in this sector is unlikely to drag down the rest of the Chinese financial system. Firstly, all estimates of the size of the sector in China indicate that it is surprisingly small. The largest of six separate estimates cited by Shadow Banking in China: A Primer places the sector’s size at 80% of GDP, versus an estimate by the Financial Stability Board that global shadow banking assets amounted to 120% of global GDP. Secondly, shadow banks are intertwined with the official banking sector, which could potentially absorb much of the damage from a crisis. Thirdly, relatively low levels of central government debt give the central government enough fiscal resources to bail out any local governments or state-owned banks that find themselves in trouble .
Escaping the Trap
As industrialising economies advance up the value chain and their citizens’ incomes increase, cheap manufacturing industries that formed the basis of their explosive economic growth begin to deliver diminishing returns. Rising wages and living standards lead to higher labour costs, incentivising companies to shift manufacturing operations to countries whose economies lie further down the value chain. So, the industrialising economy in question must alter its economic model towards one based on services and higher-end manufacturing to remain competitive. Failure to make this transition is known as the ‘middle income trap’.
The Chinese economy is on the cusp of making this transition, having already made its way into a number of high-end markets. In June 2016, for example, China surpassed the United States in the field of supercomputing: it now has the most supercomputers and the largest amount of total supercomputing power of any country in the world . However, China’s economy is still heavily reliant on the very industries it will have to cut in order to avoid the middle income trap; a reliance prolonged by dangerously high levels of debt.
Furthermore, living standards and wages are continuing to rise rapidly, prompting foreign investors to lay off staff or shift operations out of the country. China does not set a national minimum wage – each province and certain municipalities are allowed to set their own – but the average minimum wage has been rising by double digit percentages, making the need to transition to high-end manufacturing and services increasingly urgent .
A Cycle Repeated
Though the details differ, China’s debt growth is following a path trodden by many other countries. As figure 5 shows, the total debt burden has already exceeded 200% of GDP, and is fast approaching a peak matched by Spain, Portugal, Thailand and Japan, portending either rapid deleveraging triggered by a financial crisis, or gradual deleveraging in the form of economic stagnation. Furthermore, even the credit-to-GDP figure of 200% is potentially conservative since it does not account for the shadow banking sector .
Not only has the overall level of debt in the Chinese economy been trending upwards, but the composition of the debt has also been changing. Data from the PBOC indicates that outstanding short-term loans have tapered off since 2015, whereas medium and long-term loans are still growing.
PBOC data does not make clear whether the medium and long-term debt is fixed term or floating, and the PBOC stopped reporting the breakdown of loans by sector in 2010. However, the tapering off of short-term debt growth and its shrinkage as a percentage of GDP are clearly positive trends. Furthermore, the growth of medium/long-term debt is not necessarily an ominous development, especially if the debt is being used to finance productive investments with promising future returns.
Unfortunately, there is also massive overcapacity in construction and real estate, with one expert – Guo Renzhong of the Chinese Academy of Engineering – concluding that the Chinese government’s construction of new urban areas (both planned and completed) could house up to 3.4 billion people . There could not be a starker example of debt-fuelled overcapacity than this. Moreover, although an exact breakdown is unavailable, it is reasonable to assume from figure 6 that much of this construction was funded by medium and long-term debt. Unless the CCP is planning to import the rest of Asia’s population into China, this construction will almost certainly never produce reasonable returns.
Deflating the Bubble
No bubble can grow forever, especially when its growth easily outpaces economic growth overall. The Economist noted that it now takes four RMB of borrowing to generate one RMB of additional growth whereas before the 2008 crisis it was one-to-one . To bring debt down to a more sustainable level, Michael Pettis calculates that China will have to accept growth of only 3%, or less. Alternatively, productivity and efficiency enhancing reforms would have to quadruple the amount of extra growth generated by each new unit of debt just to ensure that GDP growth keeps pace with credit growth .
One possibility for resolving the debt burden is that it is not directly resolved at all. Figure 5 shows that Japan’s debt-to-GDP ratio remained flat for almost a decade before gradually falling, reflecting the country’s long period of stagnation following its economic boom. In short, the Japanese economy did not experience a sudden collapse or a Lehman Brothers moment, it simply ran out of steam.
The alternative is that a banking crisis forces everything to a head, perhaps even an ‘induced’ crisis involving a wholesale slashing of the bloated state sector. By an ‘induced’ crisis, I mean that state-owned banks – at the direction of the government – finally cease to provide cheap credit to otherwise unviable state industries, forcing most of them to cut their workforces and overall production substantially. State banks, having been forced to lend unsustainably large amounts to failing industries, would instead be forced to take enormous losses as insolvent SOEs defaulted.
Bank runs are extremely unlikely as state-owned banks, particularly the Big Four, by definition enjoy the implicit backing of the state, thereby placing the credibility of the ruling party on the chopping block in the event of a crisis. The CCP will avoid at all costs a ‘Lehman Brothers’ moment, where the government refuses to intervene to save a major bank and instead allows it to fail. Such a move would jeopardise the party’s reputation for economic competence, and it could prompt a run on many other banks. In the event of a debt crisis, state support to repair the balance sheets of state banks is, therefore, practically guaranteed. The question then becomes: how will the Chinese government finance the recapitalisation of its major banks?
Bankruptcy and Unemployment
Part of the recapitalisation could be financed by the sale of insolvent SOEs’ assets, as per normal bankruptcy proceedings. China’s State Council introduced a formal, standardised bankruptcy code in 1994, intended for winding up indebted SOEs. A special term even exists – though not a legal one – for when an SOE is made to file for bankruptcy: “policy-cruptcy” . The bankruptcy code was expanded and modernised in 2007 but, until recently, was seldom used by SOEs, which preferred to resolve financial issues through backroom deals with local and provincial governments .
Most of these “policy-cruptcies” are aimed at small and medium-sized enterprises, thus minimising the number of workers who will lose their jobs. The rest have been de-facto mergers or buyouts, whereby a larger SOE takes over, or buys a stake in, a struggling smaller firm, also in the hopes of minimising lay-offs. One of the largest and most prominent examples of an SOE going bankrupt was the Guangxi Non-ferrous Metals Group, owned by the Guangxi provincial government. The South China Morning Post reported that the company was saddled with a liability-to-assets ratio of 216.77%. After missing a coupon payment on a 500 million RMB bond and failing to propose a plan to restructure its debts, the company was declared bankrupt in 2016 .
Notably absent from the press report was any mention of lay-offs. Unemployment is a sensitive statistic for the CCP, since it directly impinges on the lives of ordinary people. In March 2016, the Chinese government announced that it would lay off 5-6 million workers over the following 2-3 years as part of a restructuring of the coal and steel sectors, with $23bn reportedly allocated to cover the cost . The statement did not mention which provinces and SOEs would be most affected, and appeared to be contradicted by another statement a week later – this time from the State-owned Assets Supervision and Administration Commission – which claimed that most of the restructuring would be done through mergers rather than bankruptcies and lay-offs .
There is little in the way of a welfare system in China, and the vast majority of coal and steel workers who will be laid off – and who may have spent most of their working lives in these industries – do not have more than a secondary school education, limiting their transferable skills. Retraining these workers is not impossible, but would further complicate life for the CCP, which wishes to avoid any social unrest that could threaten its grip on power.
The most viable option for recapitalisation would be for the Chinese government to take the losses on to its own books. This would transform toxic corporate debt into government debt, which currently makes up only a small percentage of China’s overall debt burden. The central government could use money raised from debt issuance to cover the losses of state-owned banks, with the repayment burden transferred to the tax base.
While the total amount of debt in the Chinese economy is worryingly high (and climbing), the central government is not particularly indebted compared with most developed nations. China’s public debt in 2016 was a mere 20.1% of GDP, whereas US public debt in the same year stood at 73.8% of GDP . The central government could, therefore, easily absorb the losses incurred by state-owned banks as a result of large SOEs going bankrupt. By this same logic, one could argue that the problem of SOE debt is not one of a ticking time bomb leading up to a crisis, but rather one of a giant funnel down which good money is being poured after bad. So, the challenge is to shrink or close the funnel altogether.
Furthermore, the government need not bail out every type of financial asset in the event of a crisis. In February 2017, it was reported that the PBOC, with the Securities Regulatory Commission, is drafting new rules for China’s asset management sector, explicitly stating that newly issued financial products do not have government backing. The rules would also ban financial institutions from investing the profits from their wealth management businesses in non-standard assets or loans. These new rules would drive down demand for riskier financial products and potentially reduce the amount of government debt needed for a bail-out by forcing private investors to accept losses on riskier assets .
Who would be willing to buy all those government bonds? Perhaps surprisingly, they could be popular. Chinese citizens may choose to invest their savings in government bonds, particularly central government bonds, and live off the interest payments in their retirement. For nationalist reasons, the Chinese government would probably prefer to minimise foreign creditor participation, but domestic savings could only cover a fraction of the total debt burden. Notwithstanding debt haircuts and the proceeds from asset sales, with total debt standing at 200% of GDP, attracting foreign investors to buy Chinese government bonds would be vital for any bank recapitalisation plan.
The CCP will, of course, have to make coupon payments on all that new government debt, necessitating substantial tax reform. With certain experimental exceptions, regional governments are forbidden to levy property taxes, a prohibition put in place to keep them financially dependent on the central government. Local and provincial governments instead raise revenues from a combination of income and sales taxes, debt issuance, proceeds from land sales and lump sum payments from the central government . Lifting the ban on levying property taxes would generate substantial revenue for local and provincial governments, and greatly improve their fiscal positions.
Whatever tax regime the CCP ends up adopting, the burden cannot be allowed to fall too heavily on consumers or small businesses. A winding down of state-owned manufacturing firms would mean a shifting of the economy towards one based on consumption and services, as the CCP has been seeking for some years. Shifting too much of the tax burden to households, or to the more entrepreneurial SMEs, would harm consumption and hinder the intended new engine of growth. A progressive taxation system, coupled with a crackdown on tax evasion, would provide a more robust fiscal basis for debt repayment.
The focus of any crackdown on evasion would also have to be progressive. Targeting large companies would dovetail nicely with public support for the anti-corruption campaign as well as netting far larger returns, whereas targeting households or SMEs would generate resentment against a government already perceived as corrupt and predatory. A crackdown on multinationals began in 2015 and is likely to be stepped up .
The measures outlined suggest that the CCP could slash SOEs’ share of the economy in favour of consumers and private companies, which must sink or swim without government support. However, although the CCP clearly recognises the need for economic reform, there is no guarantee that any reforms that it does end up implementing will be sufficient or timely. Allowing a greater role for private businesses would erode the party’s control over the economy and, therefore, its grip on power – a red line it would be loath to cross. Furthermore, this scenario assumes, firstly, that the CCP is willing to weather the wave of social unrest that will surely follow the laying off of millions of workers; and, secondly, that those elements in the party with vested interests in the SOEs will have been sufficiently cowed by Xi Jinping’s anti-corruption campaign to comply with the necessary reforms.
China’s debt bubble, particularly its corporate debt bubble, cannot grow forever. Failure to rein in excessive corporate debt risks either sustained, Japan-style stagnation, or a financial crisis that shakes confidence in the wider Chinese economy. Both of these scenarios would have negative long-term consequences. However, in the event that one or more major state-owned banks require government help, such assistance is essentially guaranteed. Allowing a major state-owned bank to fail – let alone one of the Big Four – would fatally damage the CCP’s reputation in the eyes of the Chinese public. It would lead not only to nationwide bank runs and a systemic crisis in the financial system, but also to nationwide anti-government protests and political paralysis – throwing the future of the ruling party into doubt.
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