China’s ratio of private non-financial debt-to-GDP has now breached 200% – a quarter above what it was in the US ahead of the financial crisis in 2008. If all off-balance sheet lending were to be included, the total would be substantially higher. Credit continues to flow towards unprofitable projects and unproductive assets that generate little or no return. Fathom estimates China’s non-performing loans problem at close to 30% of GDP, over ten times higher than the official estimate. We struggle to believe that President Xi will be willing to sacrifice lower growth for deleveraging: if and when growth falls below the government’s comfort level, we expect the clampdown on lending to be reversed.
Last month, the newly appointed Chairman of the China Banking Regulatory Commission, Guo Shuqing, said “if the banking industry becomes a complete mess…I will resign!” Since the turn of the year, numerous monetary tightening policies and efforts to curb fresh lending have been put in place. As a result, domestic bond markets are pricing in tighter liquidity conditions – last month the five-year government bond yield rose above the ten-year equivalent for the first time since the end of 2013.
However, Moody’s Investors Service, the credit rating agency, is not convinced enough will be done to avoid “China’s financial strength eroding somewhat over the coming years”. It downgraded China’s credit rating from Aa3 to A1 last week. We agree. This would not be the first time Chinese policymakers have attempted to cool credit without derailing the economy, only to reverse engines as soon as growth begins to slow. With the 19th Congress of the Communist Party just months away, President Xi will not be keen to jeopardise his reputation for bringing stability to the Chinese economy.
During the years before the global financial crisis, the growth in Chinese productive capacity kept pace with the growth in aggregate demand for Chinese goods and services – led by net exports. But when net exports fell away during the crisis, the shortfall in aggregate demand was predominately made up by a dramatic increase in Chinese fixed investment. Investment as a share of GDP was just shy of 50% in 2011 – significantly above the world average in the previous 30 years.
Since the beginning of last year, China’s policymakers have once again thrown in the towel on rebalancing and ‘doubled down’ by pursuing the old growth model of credit-fuelled investment and net trade. Both times the majority of the fixed investment was financed by loans from the bank and non-bank financial sector. According to BIS, China’s ratio of private non-financial debt-to-GDP has now breached 200%. This is already 50% higher than that of the US the year before Lehman Brothers filed for bankruptcy.
To meet the thirst for financing while also achieving their capital adequacy requirements, off-balance sheet lending ballooned after the introduction of the $586 billion stimulus package in late 2008. The difference between the blue and green line in the chart below, reflects the pick-up in the forms of shadow banking included within the total social financing (TSF) measure of credit—entrust, trust loans and banks’ acceptance bills—as well as new issuance of corporate bonds and stocks of non-financial enterprises.
The level of domestic credit to the non-financial sector as a share of GDP is an important predictor of a banking crisis in the model underpinning our proprietary Financial Vulnerability Indicator (FVI) . Using this we have examined how the probability of a banking crisis changes as a function of the level of domestic credit as a share of GDP, while assuming the other drivers in the model are equal to their sample mean across all 176 countries. As the chart highlights, beyond a debt-to-GDP threshold of around 150%, borrowing your way to prosperity no longer works and the probability that the country will suffer a banking crises starts to rise exponentially. Debt has exceeded its output-enhancing level and begins to weigh on economic growth. Eventually, this triggers a spate of debt defaults, increasing the chance of a banking crisis.
If the ratio of domestic credit to GDP in China grows at the same pace as it has done over the past ten years, by the end of the next ten, it will reach 300%. This is the amount Iceland had racked up by 2006. However, we expect a banking crisis to occur in China before we reach this point.
 Our empirically-estimated model uses a database of previous banking crises complied by Laeven and Valencia [Luc Laeven and Fabián Valencia , ‘Systemic Banking Crises Database: An Update’, IMF Working Papers 12/163, 2012]. Their definition of a banking crisis is if two conditions are met: i) significant signs of financial distress in the banking system (as indicated by significant bank runs, losses in the banking system, and/or bank liquidations); ii) significant banking policy intervention measures in response to significant losses in the banking system.
This amount of lending would be acceptable if it was being used to fund productive activities, but it is not. China’s capital stock has doubled since 2008, according to data provided by the University of Groningen. An emerging economy starts off with very little capital and therefore benefits from high returns from fixed investment. It should therefore invest more as a share of GDP than an advanced economy, letting its capital stock grow more rapidly than output. However, China has gone too far. The pace of growth in capital stock as a share of output in China is only comparable to Japan, at the time of its crisis.
As a consequence, the return on capital has plummeted, meaning investment in physical capital returns less and less over time. In other words, China’s marginal product of capital has declined. This metric is key in Fathom’s estimation of non-performing loans (NPLs). In our NPL model, the rates of return on fixed capital investment at any point in time are distributed around a mean which is determined by the whole-economy marginal product of capital. NPLs will be in the tail of that distribution characterised by a zero or lower rate of return – and the proportion of NPLs in total lending will tend to increase when the marginal product of capital falls. We should therefore expect to find that NPLs have increased during the last decade. Indeed, our estimate of China’s NPLs as a share of official GDP is now around ten times higher than the official estimate of RMB 1.6 trillion.
If you had to design a set of conditions that would undermine long-term economic prospects to the largest degree, you could not do much better than the witches’ brew being concocted in China right now. The clearest manifestation of these problems is the truly alarming build-up of debt – and the implications that it has for the health of the banking sector, and the risk of a banking crisis. If President Xi does intend to stick to his guns and do whatever it takes to “rein in financial risks” regardless of the short-term pain associated with that strategy, it will benefit the Chinese economy in the long run. However, if and when growth falls substantially below the government’s comfort level as a consequence of these tightening measures, we expect them to be reversed.
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