(Bloomberg) -- Over the past decade, China’s credit boom has been the largest factor driving global growth. That may be about to change. President Xi Jinping’s administration is encouraging banks and businesses to start deleveraging. Meanwhile, the government is committed to doubling the economy from 2010 to 2020, and getting there will almost certainly require more loans. Here, and at BI China, Bloomberg Economics looks at China’s debt problem and where it might go from here.
1. Why the World Is on Bubble Watch
In 2008, China’s total debt was about 141 percent of its gross domestic product. By mid-2017 that number had risen to 256 percent. Countries that take on such a large amount of debt in such a short period typically face a hard landing. That’s why everyone—academics, private banks, the International Monetary Fund, the Organization of Economic Cooperation and Development, the Bank for International Settlements, and People’s Bank of China Governor Zhou Xiaochuan—is sounding the alarm.
2. Earning Small Bucks, Borrowing Big Bucks
China’s debt-to-GDP ratio ranks with those of developed economies such as the U.S., the U.K., and Italy. The problem is that China is still a middle-income country, with a purchasing-power-parity-adjusted GDP per capita of just $15,400—barely a quarter of the U.S. level. Maxing out on debt at such a relatively low income level will make it more difficult for China to pay for its climb toward a developed economy.
3. Who’s Borrowing And Who’s Lending?
China isn’t the U.S. before the housing market collapse; households are relatively lightly leveraged. Nor is it Greece going into its sovereign debt crisis; government debt is low. Borrowing is mainly on corporate balance sheets: Chinese corporate debt was 163 percent of GDP in mid-2017, according to the Bank for International Settlements. Banks are the main enablers. The PBOC, the central bank, aims to have the bond market play a larger role in financing debt, reasoning that credit is allocated more efficiently in transparent, liquid markets.
4. The Warning Light Flashes
History isn’t exactly on China’s side here. A meteoric rise in borrowing without comparable economic gains rarely ends well. The IMF identified 43 credit booms in which the credit-to-GDP ratio increased by more than 30 percentage points in five years. All but five ended with a significant growth slowdown or financial crisis. China’s debt-to-GDP ratio has risen 54 percentage points in the last five years. Moreover, it started from an elevated level, increasing the chance of a crisis, according to the IMF.
5. This Is a Global Predicament …
China is now the second-largest economy in the world and the biggest trading nation, and it has the third-largest bond market. A meltdown would have global repercussions. Countries with the closest trade ties are the most at risk. South Korea, Malaysia, and Vietnam each have exports to China valued at more than 10 percent of their GDP; commodity exporters South Africa and Chile are not far behind.
6. … With a Unique Weight on U.S. Business
A financial crisis that hit the spending power of China’s middle class would also be a blow to corporate America. When China’s shift to a more consumer-driven economy created large markets for U.S. corporations, companies from Apple Inc. to Yum! Brands Inc. began to count the country as a significant source of sales and a potential growth market. At Intel Corp., for example, China rose from 13 percent of its total revenue in 2008 to 24 percent in 2016.
7. The Central Bank Holds Fast
Too much leverage reflects an abundance of credit. The obvious solution is for the central bank to raise interest rates. With inflation under control and growth uncertain, however, the PBOC has left the benchmark loan rate on hold at 4.35 percent. Repo rates, used to guide interbank borrowing costs, have edged only slightly higher. Bloomberg Economics’ China credit impulse—a gauge of new credit as a percentage of GDP—shows that new lending is no longer providing a boost, but it’s not creating a drag, either.
8. Shining a Light on Shadow Loans
Don’t mistake the PBOC’s inaction on rates as a sign that it’s giving up on the debt problem. The central bank has rolled out regulations targeting bad behavior by banks. A quarterly balance sheet review punishes those that paint outside the lines on assets or liabilities. That’s proved effective, slowing banks’ investment in risky, shadow loans and reducing their reliance on expensive and unstable short-term funding.
9. Writing Down To Get Back Up
At the local level, Communist Party cadres, bankers, and businesses are working to manage down bad loans. Banks are being strong-armed into swapping loan claims for equity stakes. Small banks are being merged into bigger ones and gaining a capital infusion along the way. A review of 2016 financial statements of 41 banks found 576 billion yuan ($83 billion at the end of 2016) in bad loan write-offs, up from 117 billion yuan in 2013.
10. Growth to the Rescue?
Perhaps the biggest support to the deleveraging agenda comes from what’s happening on growth. Measured in current prices, China’s GDP growth has accelerated to 11 percent year on year in the fourth quarter of 2017, up from a nadir of 6.4 percent at the end of 2015. Higher nominal growth means higher profits and more tax revenue—useful for paying down debt. Bloomberg Economics’ base case is that by 2022, China could face a debt-to-GDP ratio close to 330 percent, second only to Japan among major economies. If high nominal growth can be sustained, debt could stabilize at about 290 percent of GDP.
11. The Right Pace to Slow Down
Containing a debt bubble comes with its own risks. Meaningful steps to limit leverage necessarily involve slower loan growth. When that happens, markets fall and growth slows. In December, for example, deleveraging fears pushed the 10-year government yield above 4 percent and the benchmark CSI 300-equity index sold off 3 percent in one day. The risk is that steps to deleverage trigger the hard landing they’re meant to avoid.
©2018 Bloomberg L.P.