The quality versus the quantity of debt

A recent conversation with my boss prompted me to think about an interesting point. There seems to be a divergence in the way market commenters think about debt in China versus debt in developed economies. Every day in the headlines in both the English and Chinese media, the big ‘debt problem’ in China is prominent and underlines each macroeconomic discussion. The discussion often centers on the deteriorating debt position of the Chinese economy and the erosion of capacity for the Chinese authorities to manage the problem. However, to my knowledge, discussions of financial news in the US rarely features talk of an overall debt problem and to the extent there is discussion of increasing debt, it is often taken as a healthy signal that the economy is recovering. Isn’t debt the same in China as it is elsewhere? Why is an increasing debt burden regarded as negative in China while positive elsewhere?

This led me to think (and hopefully rightly conclude) that the quantity and quality of debt are two different matters. When economists talk about too much debt, it is often in the context of a bloated financial system that invested in a series of unprofitable project. Since those projects cannot recoup their original perceived value (or carrying value), then banks must write down the investment and this marks a material loss for banks and their shareholders. However, too much debt does not necessarily always lead to a financial crisis and whereas a low leverage ratio does not necessarily imply the system is immune.

If we analyze China’s debt on a purely quantitative basis, then China does not appear to have a serious problem (see Chart 1)[1]. Using the data from the Bank of International Settlements (BIS), China’s overall debt level seems consistent with many other countries. In the first quarter of 2016, China’s debt-to-GDP ratio just crept past the US’s and stands at 254.9% of GDP. Compared to some neighboring economies, China’s debt level does not seem completely out of whack; but then why all the bad press about the possibility of an imminent financial collapse?

chart-1

I would argue it is the quality and the funding structure of this debt that matters more than the absolute amount. As the Chart 1 demonstrates, Japan has had high debt levels at above 300% of GDP for many years and it has not experienced a financial meltdown. One of the reasons Japan has been able to support such a large debt burden is because most of its debt is government debt. Over the years, Japanese households, corporates and the external investors have not questioned the fiscal capacity for the Japanese state to repay. This is why (along with some help from the Bank of Japan) despite having one of the world’s largest debt burden, the Japanese financial system has not collapsed[2]. This does not in any way suggest that Japan’s path with its 20 years of deflation is an ideal one for China. However, I am trying to argue that when a national government explicitly guarantees the majority of the debt in their economy this would make the financial system more stable and less prone to a crisis[3].

What about the case for China? As Chart 2 shows, the majority of China’s debt lies in the corporate sector with its unproductive and loss-making SOEs. Unlike the case with Japan, much of this debt carries credit risk (i.e. debtors that are unwilling or unable to repay). China’s corporate debt problem started in late 2008 when the government launched a 4 trillion-Yuan stimulus package (and hence the hump in the series around that time) to counter the Global Financial Crisis. Instead of having the corporates pay for such asset expansion in equity, the majority of this stimulus was financed by bank loans and other forms of debt.

chart-2

The corporate debt problem may have begun in 2008 but it has yet to reach an end. The problem with such a rapid expansion in industrial assets is, at any time, there is a limited number of projects with positive net present value. In finance, the ultimate goal is to fund projects that can overtime repay more than what the creditors originally provide (after adjusting for risk and inflation). In late-2008, there was a limited number of projects the government could have built that were of real economic value. Due to fears of social instability, the government allowed the industrial sector to expand in excess of what was economically necessary. As a result, the industrial grew in size and occupied more and more factors of production.

In a market-economy, once firms cannot generate profit from their assets, their creditors would cut off access to new credit and the firms would have to sell assets, cut staff or, in severe cases, go out of business and declare bankruptcy. The problem in China is this natural process of resource allocation is not allowed to occur. Out of fears of social instability, the government would pressure banks to continue lending to firms to continue meeting payroll. To repay old debt, the industrial sector took on an increasing amount of new debt.

This resulted in a larger-than-otherwise industrial sector, many months of excess capacity and price deflation (see previous post for more details). The growth of industrial assets started to level off by 2014 but just to maintain the current (and bloated) asset base, more and more debt was required to refinance old interest and principal payments. In essence, more new debt was created to repay old debt: to prevent shedding assets and lay-offs, firms had to take on more and more leverage explaining why asset growth may have peaked but debt growth continues unabated (see Chart 3).

chart 3.JPG

Ultimately, it is the quality, not the quantity, of Chinese debt that should be our greatest concern. Much of these debts are invested into assets that cannot repay the original investment value its creditors thought. Instead of writing-off these assets, the banking system continues to extend credit to many insolvent firms in the corporate sector. This practice is akin to drinking to overcome a hangover with the result being a worse headache later.

Despite having decelerated, the banking sector’s exposure to the corporate sector continues to grow at twice the speed of nominal GDP. A substantial portion of this new credit is used to service economically dead loans. The government spoked many times of ‘pulling the plug’ and ‘taking away the life-support’ for many insolvent industrial firms to reduce overall corporate leverage. In the Economic Work Conference in 2015, ‘deleveraging’ was recognized to be one of the main tasks for 2016. In May 2016, the government published an article on the front page of the People’s Daily where an ‘authoritative figure’ warned ‘trees cannot grow up to the sky and high leverage must lead to high risk’. However, upon inspection of the data, there is little evidence of appetite or willingness to slow the growth of leverage anytime soon. I can only hope that when debt level finally stabilizes, it will proceed in an orderly manner where the government has ample fiscal and coordination capacity help those affected. The sooner this occurs, the lower the likelihood of a market-forced adjustment that will be more painful and destabilizing for both the financial system and the broader society.

[1] Here I am ignoring the arguments that more developed economies can sustain higher levels of debt; that is not the point of this piece.

[2] Obviously factors such as Japan running persistent current account surpluses contribute to their debt servicing capacity but that is a discussion for another day.

[3] For this statement to be true, the said country must run an independent monetary policy and can issue their own currency. The details of this will be a discussion for another time.

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