China’s bad dream

Since his first address as China’s president last year, Xi Jinping has been espousing the so-called “Chinese Dream” of national rejuvenation and individual self-improvement. But the imperative of addressing the unprecedented amount of debt that China has accumulated in recent years is testing Xi’s resolve – and his government is blinking.

The Chinese government’s uncertain ability – or willingness – to rein in debt is apparent in its contradictory commitment to implement major structural reforms while maintaining 7.5% annual GDP growth. Given that China owes much of its recent growth to debt-financed investment – often in projects like infrastructure and housing, meant to support the Chinese Dream – any effort to get credit growth under control is likely to cause a hard landing. This prospect is already prompting the authorities to delay critical reforms.

To be sure, China’s debt/GDP ratio, reaching 250% this month, remains significantly lower than that of most developed economies. The problem is that China’s stock of private credit would normally be associated with a per capita GDP of around $25,000 – almost four times the country’s current level.

There are strong parallels between China’s current predicament and the investment boom that Japan experienced in the 1980s. Like China today, Japan had a high personal savings rate, which enabled investors to rely heavily on traditional, domestically financed bank loans. Moreover, deep financial linkages among sectors amplified the potential fallout of financial risk. And Japan’s external position was strong, just as China’s is now.

Another similarity is the accumulation of debt within the corporate sector. Corporate leverage in China rose from 2.4 times equity in 2007 to 3.5 times last year – well above American and European levels. Nearly half of this debt matures within one year, even though much of it is being used to finance multi-year infrastructure projects.

Making matters worse, much of the new credit has originated in the shadow-banking sector at high interest rates, causing borrowers’ repayment capacity to become overstretched. One in five listed corporations carries gross leverage of more than eight times equity and earns less than two times interest coverage, weakening considerably these companies’ resilience to growth shocks.

To be sure, China’s situation is more extreme than Japan’s. At its peak, Japanese investment stood at 33% of GDP, compared to 47% in China. This is a substantial difference, especially considering that China’s per capita GDP amounts to only 19% of Japan’s at its highest level, and that its debt has already reached 60% of Japan’s. Moreover, the accumulation of debt in China – 71 percentage points of GDP over the last five years – has been far sharper than in Japan, where the debt level grew by only 16 percentage points over the five-year period before its bust.

That is all the more reason to believe that Japan’s experience can provide important insight into the risks that China faces. After Japan’s bubble burst, annual GDP growth, which averaged 5.8% in the four years preceding the bust, plummeted to 0.9% for the next four years. With bad debt left to fester on banks’ balance sheets, growth vanished and deflation set in. While private debt as a share of GDP stabilised, public debt increased by 50% in the five years after the bust.

The collapse of China’s credit bubble would likely cause annual GDP growth to drop to 1-2%, on average, for the subsequent four years, assuming a 2% annual decline in capital expenditure and a still-respectable consumption-growth rate of 3-5%. Consolidated public-sector debt would rise to 100% of GDP. This is a relatively modest prediction. Without automatic stabilisers or a strong financial-stability framework underpinned by deposit insurance, coping with the downside risks of the potentially destabilising financial reforms that the government is pursuing will be difficult enough; a credit shock could prove disastrous. China’s debt tipping point is to be found in its massive real-estate bubble. According to the investment bank UBS, new urban housing supply has far exceeded marginal underlying demand from urban population growth. Indeed, almost half of the formal increase is not an increase at all, but merely recognition of rural workers who have been living and working in cities for some time. The impact of a sharp decline in real-estate prices would be farreaching. After all, property collateral is the bedrock of the Chinese financial system, with estimates of banks’ direct and indirect exposure to real estate ranging from 66% to 89% of GDP.

Complicating matters further is the government’s lack of options for stabilising property markets. In fact, a key part of the problem is that China’s response to cyclical weakness always entails more housing construction.

China’s lack of automatic stabilisers places the tension between reform objectives and growth imperatives in sharp relief. The only way for the government to shore up growth in the short run is to pursue more debt-driven stimulus, as it did earlier this year. But this will also cause China’s debt burden to continue to grow, with bad debt increasingly crowding out good credit.

If China’s leaders continue to choose debt-fueled growth over reform, they will only delay, and possibly prolong, the inevitable slowdown. That would turn Xi’s Chinese Dream into a more elusive prospect.