A radical new cure for China’s hypertension debt load
No point fretting over sky-high corporate leverage when the solution is simple: focus where returns are highest. Well what are we waiting for?
The butterflies suffered by hypertension patients when taking their blood pressure closely mirrors what many of us China analysts go through while waiting for the People’s Bank of China to release its monthly banking statistics.
A large loan number might trigger a bloom of rose-tinged flights of fancy — that, for example, it signals the central bank is opening a powerful spigot of liquidity in order to propel growth. Or perhaps it’s evidence of a rebounding economy thirsty for bank financing. A smaller-than-expected credit figure will, of course, have the opposite effect, etching deep frowns onto the brows of investors.
Is bigger always better? Is smaller necessarily bad? The boffins at the PBOC say that the key is really to put loans into the right hands, something they call “enhancing debt productivity.” To do so, China needs to focus more on market forces and cut back on government interventions, they suggest.
In the latest working paper from the central bank, researchers delved into the pressing issue of China’s rampant leverage and warned of financial risks brewing in the background under the current way credit is doled out in the economy.
China’s corporate leverage ratio — or the total amount of debt in the nonfinancial business sector relative to annual GDP — is already the fourth-highest in the world at 167.6% as of the end of June, 2016, according to Bank for International Settlements data. In fact, only the international offshore financial centers of Luxembourg, Hong Kong and Ireland are more leveraged. China now accounts for US$18.4 trillion of the US$25.4 trillion global total of emerging market nonfinancial corporate debt, according to the IIF’s Global Debt Monitor published in January 2017.
Since 2008, debt has been piling up primarily in China’s state-owned enterprises, which faced the stark reality of flagging returns on assets in recent years, the paper noted. In comparison, the private sector achieved superior returns with a substantially lower debt burden.
Such structural misallocation of capital toward the less profit-oriented SOE sector is a major factor preventing China’s economy from exiting the prolonged period of slower growth.
Chinese banks, predominantly controlled by the government, shun privately run entities in favor of state-affiliated businesses for a variety of reasons, including their generally small size and the sheer number of businesses, as well as the age-old difficulty in assessing their creditworthiness.
Furthermore, the race among government officials seeking a career boost through their stewardship of the areas under their control has driven the diversion of capital towards infrastructure, heavy industries and real estate development.
Such incentive mechanisms have resulted in ever-rising leverage for SOEs, government-affiliated businesses and property developers.
Total leverage in China outside of the banking system — which aggregates household, corporate and government debt — stood at 254.9% of GDP as of 2Q 2016, nearing the levels of developed economies.
Household leverage rose quickly to 41.8% as of 2Q 2016, low in absolute terms but more than doubling since 2008’s 17.9%.
Fortunately, China’s high-savings rate and hence its domestically financed investment-led growth pattern allows the economy to endure — and even sustain — a relatively high leverage ratio compared with other nations, the authors argue. Of course, neither is the sky the limit.
And let’s not forget that with a higher debt level comes a greater burden of interest expenses. The paper noted that a large portion of China’s annual debt expansion — between 40% and 50% — is used solely to service the interest on existing debt. With the prospect of interest rates edging higher globally this year, the problem of rising debt-servicing costs doesn’t affect only China. “Higher borrowing costs could raise concerns about debt sustainability,” the IIF’s report said.
Higher interest payments encroach on fresh, available credit for productive investments, hence suppressing ‘’debt productivity.” The spiral of debt-interest-debt, if not handled carefully, constitutes a serious challenge to financial stability.
“We believe that the process of deleverage should be managed prudently, i.e., efforts should be made to avoid a liquidity crisis and a ‘debt-deflation’ trap due to rapid deleveraging, and to avoid asset bubbles due to a rapid increase in leverage,” the PBOC’s researchers, including Lee Hongjin, remarked in their conclusion.
The key to breaking the vicious cycle of climbing leverage is to let market forces evaluate risk and reward, and allocate capital accordingly. Doing so would help ensure funds reach the most appropriate investment opportunities, enhancing the usefulness of every single yuan loaned by banks, and boosting debt productivity in China.
With a cure as simple as this, those butterflies should soon be just a nasty memory, and no more hypertension in our analysts. Right?