China’s great leap forward economically has now led the communist nation to join its developed rivals in the major debtors club. With growth slowing, is the world’s second-biggest economy heading for a crash?
According to a new report by the McKinsey Global Institute (MGI), China’s debt has quadrupled from $7 trillion in 2007 to $28 trillion as of mid-2014, reaching 282 percent of gross domestic product (GDP) and higher than the level of the United States. Continuing its current pace of growth would see China’s debt reach 400 percent of GDP by 2018, the equivalent of Spain.
Commenting on China’s debt explosion, the report said: “Several factors are worrisome: half of loans are linked directly or indirectly to China’s real estate market, unregulated shadow banking accounts for nearly half of new lending, and the debt of many local governments is likely unsustainable.”
According to MGI, property prices have risen by 60 percent since 2008 in 40 Chinese cities, with residential prices in prime locations in Shanghai now only about 10 percent below the level of New York and Paris. A sustained slowdown would hit the housing construction sector that accounts for 15 percent of GDP, while banks would suffer the fallout, particularly city commercial banks where real estate accounts for up to 30 percent of their loan portfolios.
As much as $9 trillion of debt is directly or indirectly linked to the real estate sector, including most of the loans by the shadow banking sector, with loans of around $6.5 trillion. In addition, slowing property markets increase the risk of a blowout in local government debt, with up to 40 percent of debt servicing and repayments funded by land sales.
Borrowing by local governments has grown by 27 percent a year since 2007 – 2.5 times as fast as the central government’s. According to a Standard & Poor’s report issued in November 2014, as many as half of the provincial governments would fall below investment grade, with most having debt to revenue ratios exceeding 100 percent.
Already, a property correction is underway with a 14 percent fall in the value of residential property transactions in 40 Chinese cities between April 2013 and August 2014, although Beijing saw a steep 33 percent dive and Shanghai dropped 21 percent.
MGI said the Chinese economy accounted for more than one-third of global growth in debt since 2007, with the largest driver being borrowing by non-financial corporations, including property developers. At 125 percent of GDP, China has one of the highest levels of corporate debt in the world, it said, noting that “rapid growth in debt has often been followed by financial crises.”
“A plausible concern is that the combination of an overextended property sector and unsustainable finances of local governments could result in a wave of loan defaults in China, damaging the regular banking system and potentially creating a wave of losses for investors and companies that have put money into shadow banking vehicles,” it said.
While spillovers to the global economy would be reduced due to the fact that China’s capital account is not fully liberalized, any further slowdown in Asia’s biggest economy would hit growth prospects for its regional trading partners.
Beijing is reportedly targeting a “new normal” growth rate of 7 percent for 2015, but economists see even this lower target posing a major challenge. The International Monetary Fund recently downgraded its GDP growth forecast for China from 7.4 percent in 2014 to 6.8 percent this year, while Oxford Economics has suggested this year could be the last time it even reaches 6 percent.
On February 28, China’s central bank cut both deposit and lending rates by 0.25 percentage point, with the economy’s softness shown by its key manufacturing index staying below 50 for two straight months.
Commenting on the rate cut, ANZ Research said it was a “response to the slowing growth, rising deflation risk and the elevated lending costs faced by the corporates,” with China facing “significant capital outflow.”
Asian Financial Crisis?
A senior Chinese government official has told the Australian Financial Review that conditions appear “more and more like the Asian financial crisis,” with as much as $80 billion leaving the country in December alone. The capital flight has sparked concerns of a sharp decline in the exchange rate causing a credit crunch among indebted corporate borrowers.
In 1997, capital flight from Thailand, Indonesia and South Korea caused currencies to plunge, sparking a region-wide banking crisis. Similar to 1997, rising interest rates in the United States also encouraged capital flight from the emerging economies.
According to ANZ economist Liu Li-gang, Chinese companies have around $1 trillion of external debt, with 80 percent of it borrowed from short-term money markets. A lower exchange rate would increase debt servicing costs for these borrowers, further damaging the prospects for the economy avoiding a hard landing.
ANZ said it expected more rate cuts from China’s central bank along with an increase in the fiscal deficit, from 1.9 percent of GDP in 2014 to 2.2 to 2.3 percent this year, to help support the official growth target.
According to MGI, Beijing could help avert a debt crisis by strengthening local government finances, such as by giving them the right to levy property taxes. Other measures could include ensuring more accurate credit ratings and increasing transparency across the financial system, including developing better property data; making bankruptcy easier; and further liberalizing the financial system to reduce reliance on bank deposits and real estate, along with a stronger social safety net.
Beijing has already moved to get a clearer picture of the extent of local government borrowings, including ordering local governments to bring non-profit generating projects back onto their balance sheets. But while it “has the financial capacity to handle a financial crisis if one materializes…the question is whether China could manage this without a significant slowdown in GDP growth,” MGI said.
With potential political repercussions for China’s leaders, propping up a faltering economy while preventing a financial crisis will give policymakers plenty to worry about in the Year of the Sheep.