How worried should we be about the soaring levels of debt in the Chinese economy?
This question has been hotly debated this week, after Beijing released figures showing that borrowings by Chinese local governments had climbed to 10.7 trillion yuan ($US1.65 trillion) in debt, equal to a staggering 27% of China’s GDP.
Many analysts were quick to point out that these figures severely underestimated the problem (Beijing’s inflation fight), and the actual number could be considerably higher. For instance, Professor Victor Shih, of Northwestern University, estimates that local government debt was close to $2.6 trillion, or 42% of GDP, at the end of last year.
There are also concerns about the quality of these loans, with as many as 20% to 30% likely to be at high risk of souring. Already there are rumours that some local government investment vehicles — the arm’s-length financing vehicles that local governments set up to get around restrictions on borrowing — are beginning to default on their loans, and that more defaults are in the wings.
It now seems inevitable that the central Chinese government will have to step in and assume responsibility for many of these problem loans. This will push up China’s explicit debt burden, which most analysts believe is currently about 70% of GDP.
But if you include debts on the books of state-owned enterprises and other entities implicitly backed by the state, the debt burden of the Chinese government is considerably higher. According to Professor Shih, “if you take a very broad view of the Chinese government’s contingent liabilities rather than explicit debt on the books then the number comes to well over 150% of China’s GDP in 2010.” This compares with the United States, which has a debt-to-GDP ratio of 93%, and Japan, where the debt-to-GDP ratio is more than 225%.
In his latest newsletter, Professor Michael Pettis — a professor at Peking University’s Guanghua School of Management — also adopts a broader approach to China’s debt problems. He argues that the problem in China is not local government debt, but rather the high level of indebtedness through the economy.
He points out that many Chinese state-owned enterprises have diversified their activities far beyond their original sphere. For example, he says Minmetals, China’s largest metals trader, has a real estate development arm that is currently building a replica of the Austrian village Hallstatt in Guangdong province.
“In fact a lot of Chinese SOEs are involved in a very wide variety of business activities, and are especially fond of activities in which cheap capital is the comparative advantage, or in which there is political advantage to be gained. That makes real estate development and ‘high tech’ two of the most popular ancillary businesses.”
There are, he says, strong incentives for Chinese companies to borrow heavily and bulk up on assets. Chief executives of larger companies are more important and better remunerated. They also get to spend more time with senior political leaders. What’s more, as Beijing tries to force smaller companies to amalgamate, it’s likely to be the boss of the larger company that gets to keep his job.
In addition, by borrowing money in order to acquire assets, Chinese companies get to make full use of their chief comparative advantage — their access to cheap capital. Even if they overpay to acquire assets, in time these investments appear profitable due to China’s artificially low interest rates.
“The fact that nearly every important SOE, and many not-so-important ones too, have real estate development subsidiaries probably has a lot more to do with access to cheap capital and the opportunity to share in the real estate bonanza than with any real ability to add to the underlying wealth of China,” he says.
But, Pettis adds, this build-up in debt is not accidental. “It should have been clear for many years that China’s investment-driven growth model was leading to unsustainable increases in debt.” Even if Beijing now clamps down on lending, it won’t solve the underlying problem.
“In all previous cases of countries following similar growth models, the dangerous combination of repressed pricing signals, distorted investment incentives, and excessive reliance on accelerating investment to generate growth has always eventually pushed growth past the point where it is sustainable, leading always to capital misallocation and waste. At this point — which China may have reached a decade ago — debt begins to rise unsustainably.”
Pettis argues that Beijing now faces the problem that rapid growth comes at the expense of an ever-riskier, and ultimately unsustainable, rise in debt levels. “Eventually either they will choose sharply to curtail investment, or excessive debt will force them to do so. Either way we should expect many years of growth well below even the most pessimistic current forecasts.”
But not yet. Pettis estimates that “high investment-driven growth” is likely to continue for at least another two years.
*This first appeared on Business Spectator.