After years of rapid economic growth, China is facing a crisis in the form of one of the highest debts in the world.
China is in an economic conundrum again. While the debt-to-GDP ratio in China is rapidly growing, the growth rate is slowly declining. A similar situation has recently been seen in the Western world too, but with somewhat a successful solution of avoiding a credit crunch albeit, at the expense of the sustainability of the public sector. It is high time China finds a way too.
Corporate debt is China is currently at $18 trillion, which is equivalent to 169% of the economy’s GDP. A majority of these companies are owned by the State, and their debt exceeds $2.8 trillion or 90% of the total debt. In the worst scenario, if the credit ratio in Chinese banks, which was 5.6% in 2016, reached 11-17%, the banks would need about $1.7 trillion for recapitalization. Now they need $500 billion. The IMF has already warned China that its credit growth is unsustainable and its Banking Regulatory Commission also has issues warnings that non-performing loans are already at about 2%.
China has for years devalued its currency. It lost nearly 1% against the dollar in this year, after losing 2.5% last year. Investors have already lost faith in China’s future growth and stability and have already started pulling money out of China, which can be the start of new problems. Chinese companies may find it much harder to repay their debt if the Yuan continues this trend. With the liberalization process continuing and the market having a greater role, it would become rather difficult to control the exchange rate, as well as the flow of money into the system.
In order to resolve the deepening debt crisis and decline of economic growth, the PBOC plans to implement a multi-pronged tool that includes cutting off companies’ debt through encouraging mergers and acquisitions, due bankruptcies, debt-to-equity swaps and debt securitization to improve credit allocation. This should redistribute the debt load, but the question is whether the economy-wide leverage would be reduced. China relies too much on state-owned companies to generate economic growth, although they border on inefficacy compared to the private sector.
If China plans to deleverage its debt, it must be a cautious move. Deleveraging and slower nominal growth form a vicious circle. Debt capacity depends on future output growth, inflation rate and the interest rates. However, since it is expected that economic growth in China will decline in the coming years, the deleveraging process will be harder. The government policy for successful deleveraging must include many measures. It is not enough only to apply appropriate monetary policy, but it is also necessary to consider fiscal challenges, macro-prudential policies and the restructuring of private-sector debt. The banks could swap debt for equity, which will reduce borrowing, and gradually debt. However, the overly indebted companies should be left to go bankrupt, because their rescue remains almost impossible and would negatively impact the rescuing of other relatively better performing companies that have a chance to get out of the debt crisis. On the other hand, since most of China’s borrowing is domestic and the banks have stable funding, China’s financial system does not seem as vulnerable as western countries were, in the 2007-08 crisis. Increased transparency would also give investors the confidence to invest more in the sectors with higher returns, which will reduce the necessity for borrowing. In addition, a targeted fiscal stimulus would be helpful in returning of confidence in China’s growth prospects and its currency. Wider economic reforms always bring a solution in the long term.