China has a dangerous addiction to US dollar debt
China’s foreign debt has been rising rapidly, and that’s becoming an increasingly big problem — for the country and, potentially, the world.
Officially, China lists its outstanding external debt at US$1.9 trillion ($2.8t). For a US$13t economy, that’s not a major amount. But focusing on the headline number significantly understates the underlying risks.
China’s foreign debt balance has surged in the past decade.
Short-term debt accounted for 62 per cent of the total as of September, according to official data, meaning that US$1.2t will have to be rolled over this year. Just as worrying is the speed of increase: Total external debt has increased 14 per cent in the past year and 35 per cent since the beginning of 2017.
External debt is no longer a trivial slice of China’s foreign-exchange reserves, which stood at just over US$3t at the end of November, little changed from two years earlier. Short-term foreign debt increased to 39 per cent of reserves in September, from 26 per cent in March 2016.
The true picture may be more precarious. China’s external debt was estimated at between US$3t and US$3.5t by Daiwa Capital Markets in an August report. In other words, total foreign liabilities could be understated by as much as US$1.5t after accounting for borrowing in financial centres such as Hong Kong, New York and the Caribbean islands that isn’t included in the official tally.
Circumstances aren’t moving in China’s favour. The nation’s companies rushed to borrow in US dollars when there was a 3 per cent to 5 per cent spread between Chinese and US interest rates and the yuan was expected to strengthen. Borrowing offshore was cheaper and offered the additional bonus of likely currency gains. Now, the spread in official short-term yields has shrunk to near zero and the yuan has been depreciating for most of the past year.
Beijing’s policies have exacerbated the buildup of foreign debt. To promote Xi Jinping’s Belt and Road Initiative, the president’s landmark foreign policy endeavour, China has been borrowing dollars on international markets and lending around the world for everything from Kenyan railways to Pakistani business parks. With this year and 2020 being the peak years for repayments, China faces dollar funding pressure. To repay their dollar debts, Chinese firms will either have to draw from the central bank’s foreign-exchange reserves (a prospect Beijing is unlikely to allow) or buy US dollars on international markets. This creates a new set of problems. There are only 617 billion yuan ($131b) of offshore renminbi deposits in Hong Kong available to buy US dollars. If China was to push firms to bring debt back onshore, this would necessitate big outflows that would push down the yuan’s value against the US dollar.
International dollar investors need to be wary of Chinese-linked investments. Local government financing vehicles and belt-and-road borrowers may seem quasi-sovereign quality, but any shift in the willingness to roll over dollar debt could create a funding crunch. With the US Fed raising rates and reducing its balance sheet, Chinese companies could face paying more for capital in dollars than in yuan.
Bulls have long argued that China’s financial risks are contained because of the country’s low levels of external debt and large foreign-exchange reserves. That has changed.
China’s external debt has been increasing by an average of US$70b per quarter since the beginning of 2017. If it keeps rising, Beijing will have the unpalatable choice of burning through its reserves or letting the yuan fall, both of which would carry additional risks.