China’s Economy: Debt, Financial Risks, and Structural Challenges

Welcome to Pacific Exchanges, a podcast from the Federal Reserve Bank of San Francisco. I’m Cindy Li.

I’m Paul Tierno. We work in the country analysis unit and our job is to follow what’s going on in Asia. Today, we continue our series Rethinking Asia as we consider noteworthy and unusual trends in Asia and finance and economics. In the next two episodes we will be taking a close look at China’s debt situation.

We sat down with Yukon Huang, a senior fellow with the Asia program at the Carnegie Endowment for International Peace. Yukon is a well- respected China expert. He was formerly the World Bank’s country director for China and advises various governments, corporations, and multilaterals such as the Word Bank, Asian Development Bank, and the Asian Infrastructure Investment Bank. Yukon’s research focuses on China’s economy and its regional and global impact.

Great. Let’s get to our conversation with Yukon.

It’s great to have you, Yukon.

It’s great to be with you all.

Yukon, here at the Country Analysis Unit, we closely follow China’s economic and financial market developments. The Chinese economy has achieved remarkable growth over the past several decades, but in recent years, we are reading more and more about potential financial sector risks. One data point is between 2012 and 2017, China accounted for more than 80% of the growth in emerging market debt according to BIS data. Yukon, for the benefit of the audience, can you give us a brief overview of China’s growing debt? Who’s borrowing and who’s lending? Where does the growth come from and why is this important?

Sure. It’s important to realize that when you look at China’s debt-to-GDP ratio, analysts tend to break it down into three components. One is corporate debt. The other is government debt, and then there’s household borrowings. Today, the total ratio of debt- to-GDP is approximately 250% to 260% depending upon the definitions that one uses. Now, this compares with a ratio of about 150% just before the Global Financial Crisis. China’s overall debt-to-GDP ratio has increased by about 100 percentage points of GDP. This is what most people are alarmed by because very few countries have seen such a big increase. For this particular period, most of this increase was accounted for by the increase in corporate borrowing.

I might also add that the source of funding has changed slightly. If you go back 10 years ago, most of the borrowing was concentrated among the big four or five state owned banks, but increasingly over the last seven or eight, nine years, a lot more borrowings are coming from what I call city and local banks. Some of them are private. Most of them are affiliated with provincial governments, so now the big four state owned banks who used to account for maybe 80% of the credit flows, they probably account for maybe 40or 45% percent. A very large share is now coming from these smaller banks that are usually linked with the local governments.

Yukon, what about non-banks? Are they also providing an increasing share of the credit?

Well, this increase in total credit expansion includes resources which are flowing through non-bank intermediaries, shadow banks. The interesting thing about shadow banking in China is it essentially did not emerge until around 2007 or 2008 coinciding with the onset of the Global Financial Crisis and coinciding with what I call a big stimulus program that the government put in place around 2008. That stimulus program was largely channeled through the monetary banking system. It not only provided funding for local governments and other entities to expand their capacity, either infrastructure in the case of local governments or plant capacity in the case of enterprises, but it also spawned a lot of liquidity, which created a non-bank shadow banking market.

These came through products issued by trust companies, wealth management products created by the banks themselves, which were not treated as the formal deposits, an increase in the bond market. All sorts of informal kinds of lending activities emerged during this period of time. The interesting aspect of the shadow banking is that much of the growth in credit flows over the last 10 years –the cyclical changes in the growth rate – are largely accounted for by the cyclical pattern of expansion of shadow banking. The lending that has gone through the state or the normal formal banking sector per se, which people refer to as RMB lending, that more or less has been relatively stable and declining in some ways, but the expansion really came from shadow banking.

Thanks for the big picture, Yukon. Looking at the overall magnitude and the composition of the debt, should we be worried? If so, why?

Well, if you go back three or four years ago, and also I would say it’s starting to emerge again today, you read a lot of concern about the possibility of a debt crisis. It begins with the analysis of the fact that the debt-to-GDP ratio has increased so dramatically, and by some indicators, this increase over the last 10 years is, compared to other countries or historical experiences, exceptional only maybe a handful of countries have experienced an increase in debt of a similar magnitude within such a short period of time. That’s very alarming. You have agencies like BIS who published the so called indicators signaling risks. At various times, they said that China’s risk indicator is alarming.

Very few countries or practically no countries who’ve experienced such a rapid increase in debt have been able to avoid a financial crisis. So predictions of an imminent collapse were a commonly held view a couple of years ago. They moderated in the last couple of years because China’s debt-to-GDP ratio has leveled off and stabilized, but it started to surface again because of the trade problems and the potential for the government to institute more expansionary policies in the coming years. The focus has been on the increase, the rate of increase of the debt as being a problem.

If you actually look at the ratio, the absolute number, which is somewhere around 250% or 270% of GDP, depending on what you include in there, and you put that ratio against what I would call the 100 largest economies in the world, what is interesting is that China’s ratio is actually right in the middle even after this huge increase. It is larger than most developing or emerging market economies. It’s at the low end of most developed economies. Now, if you think about it and you had to guess where China’s debt ratio might be, this is probably where it should be. It’s really not an emerging market economy. It’s not really a developed economy. It’s right striving at the border. In fact, that’s what it is.

When I look at the issue, I say to myself, “The debt-GDP-ratio, putting aside the rate of increase, is exactly what I thought would be reasonable for an economy of its structure and its nature,” but the surge, the increase is unusual. That’s why many analysts said that this is what matters. It’s not the level actually. It’s the rate of increase in such a short period of time. From their perspective, this is a strong signal of a potential debt problem.

Not all debt is bad, of course. In fact, deep capital markets are critical for a modern economy. Some may argue that there is an undepreciated challenge as countries like China use debt to achieve growth and development. Would you agree?

Well, let me go back a step first because I think it’s related to your question of what would be the logical evolution of a financial system as China moves from let’s say, low- to middle- to upper-income levels, and how much progress has China made in terms of that evolution of what I call a sensible and sound financial system. The first issue would be this surge…this increase in debt as a share of GDP, which puts China in a very unique situation because very few countries have seen such a surge and which therefore drives the concern about its debt problems. How do we explain this surge?

In my research, I’ve basically pointed out there’s something very different in China compared to other countries, and the primary difference is that China did not have a private property market 10 or 15 years ago. It only got created in the early 2000s. Land auctions only were instituted in 2004. A secondary and wholesale private land market and property market really only began to emerge around 2005, 2006, or 2007. This coincided with the Global Financial Crisis. It coincided with the monetary expansion, the government’s stimulus program. Here’s something unique and coincidental. You have a huge stimulus program, which is channeled through the monetary financial system. It coincides with the emergence of a private property market in China.

The consequence is that land values or property values have increased about 600% in the last decade in China. Now in the West, whether you’re sitting in the United States or in London or elsewhere, if property prices go up by 50% or 100%, people are worried about a potential property bubble. The interesting question is why is that a 600% increase in China does not seemingly have led to a property bubble? Secondly, what is the implication of a 600% increase on the debt market and development of financial institutions? Well, let me go back to the impact of the property surge on the debt indicators.

If your property markets, which are essentially driven by the price of land, go up five or six fold and people are borrowing against it in terms of mortgages for households or local governments are buying the land to put in roads and infrastructure, and having to pay for it through revenues or also through bond borrowings and other forms of lending, the debt surges because the price of the property is so much higher. Now, that’s your debt. Your debt is being driven by the increasing prices of property related assets. That’s the numerator of your debt-to-GDP ratio, but what’s happening to GDP with this property market surge? The answer is it doesn’t change because the price of land as it increases doesn’t count in GDP.

The transfer of land-based assets does not count in GDP, so the denominator doesn’t increase, but your numerator does dramatically. This property market price acceleration accounts for about 70% of the increase in the debt ratio in China and largely explains the surge. It largely explains why it’s so unusual because in all the other economies that we’ve been looking at and financial analysts look at, they already had private property markets for generations. They’ve never experienced a six-fold increase in a relative sense. If there is a debt surge, it’s not driven by the property market. It’s driven by other kinds of factors triggering debt.

I basically concluded that the issue therefore is: are these property prices sustainable? Because if they are, you don’t have a debt problem in China, but if these property prices are not sustainable, then you face a potential collapse in property prices, which then triggers all sorts of consequences in terms of the financial banks, and people have been lending against the value of this property. Now, it’s interesting to note that today, property prices in China, even after a six-fold increase are about 30% to 40% lower than property prices in India, and no one talks about debt bubble in India. They talk about debt bubble in China.

I am fairly sanguine in terms of the increase in the debt, but I’m not so sanguine about the composition, the emergence of shadow banking, the role of the banks, the institutions, the financial development in this country, because that is still going through what I call a fairly piecemeal evolution that has not yet been really addressed seriously. This relates to your question about the financial institutions, the markets. The bond market for example is still not well developed. It’s essentially state enterprises and local governments selling bonds to the banks. It’s not really a private market based.

Shadow banking is somewhat of a black hole. People still don’t know exactly what the purpose is of the monies being used. The risks are not clearly identified. The people purchasing these shadow banking instruments or putting the deposits into them are relatively unsophisticated, so there are risks in that area. Then there’s, I would say, the major risk. Maybe 70% to 80% of the financial institutions engaged in lending are state owned or state related, so the question of accountability, who do they lend to? In many cases, the banks in the provinces in these major cities, they’re essentially lending to local authorities, or they’re captive lenders to state interests, and that of course could lead to potentially bad kinds of investments and it reduces the accountability in the system.

These kinds of issues in China are relatively unique in terms of the problems we see, and they are risks that the government does have to deal with.

Yukon, you seemed to be suggesting that instead of some imminent debt crisis, what we are really looking at here are chronic problems that may have some negative consequence on efficiency of the economic system, but not an outbreak of a debt crisis in the near future. Am I right?

Yes. The problem in China is more structural than financial, but let me clarify what I mean. Normally when you think of a debt crisis, you tend to think of banks or the financial system. You tend to think of non-performing loans. You tend to think of chain effects of institutional collapses as ripple effects through the financial markets, and you tend to think that the problem is that the banks are undercapitalized or they’re not properly being regulated or there is an issue in terms of who they’re lending to, or the people are speculating more than is appropriate. That’s what you generally look at.

In this particular case of the last 10 years in China, I would say the issue in China is not actually a banking issue. It’s more of a fiscal issue, a budget issue, because one of the new things that’s been happening is that local governments, they have not been able to secure the revenues needed commensurate with their fiscal responsibilities, primarily social, health, infrastructure expenditures. They don’t really have access or are credit worthy enough to float bonds. What they’ve been doing to finance what I call their fiscal expenditure needs is that they’ve been using land that they control to borrow and much of that through the shadow banking system, and then they use those loans for what I call normal government expenditure responsibilities, plus what I call speculative commercial activities, building shopping centers or whole scale housing projects.

You read about these ghost cities with 50,000 potential buildings that could accommodate 50,000 people but they’re totally empty, but the idea that they’re trying to do here is they’re trying to earn money because they don’t have the tax revenues. Unless you can solve this kind of a fiscal problem in China, you have this problem that local authorities, unlike local authorities in the West, they borrow primarily for expenditures which should be financed from tax revenues. In the West, you couldn’t do this. This is a fiscal problem, a structural problem. It’s not really a banking problem to the extent that the lenders have a problem or to the extent that the borrowers are not really doing appropriate things.

These are all state agents, lending to state agents. This basically then becomes, if you think about credit worthiness or financial problem, it’s a question of whether the overall government, whether China is credit worthy. By that measurement, China doesn’t really have a problem because its overall budget situation, its overall assets, its overall reserves are very, very strong. The issue is much more of a structural issue or what they’re doing with this money, the nature of the fiscal system, and much less a banking issue of the form that we’re used to thinking about.

I guess because China ranks very high in terms of trade openness, but probably if you look at the financial openness, China is still relatively closed compared to most advanced economies. The system works as long as the financial markets remain relatively closed. Most recently, we’ve seen a lot of efforts from the Chinese government to open up its capital markets to foreign investors. Do you feel this may eventually increase the possibility of repricing of asset prices?

China’s domestic financial markets and its economy in general is cut off from the global markets, as you mentioned, because the capital account is not fully open. They’ve had extensive controls on the flow of funds into China. Investment banks, financial intermediaries who want to bring money into China have to secure applications and be approved for how much they can bring in. I as an individual, when I was living in China, I could not wire into my bank account more than $5,000 a month without getting approval from the government to do so. You have a very tight control over money coming into China. Then you have tight controls over money leaving China, so if you want to move your money out of China, you have to basically go through an approval process.

Now, the government’s loosened this process up over the years, particularly in terms of letting more funds coming in and connecting their stock exchanges with the stock exchange in Hong Kong and elsewhere, and so there are ways, in fact, in investing in China today, which were not available 10 years ago. They’ve also loosened up the ability of firms and households to move their funds abroad if they wanted to, for let’s say, invest in property or mergers and acquisitions overseas. Companies which were earning foreign exchange and park this foreign exchange in their accounts overseas never had a problem in terms of getting access to foreign exchange or moving their money around, but those companies which were essentially earning RMB have always had a problem converting the RMB to dollars.

About two or three years ago, China actually loosened up a lot, making almost fairly easy for anyone to move their funds overseas as they wanted to. The consequence of that was the total reserves fell dramatically and the exchange rate was under pressure. For about six months to a year, you had this issue of whether it was capital flight and whether the government was opening up its capital account too dramatically, but then they tightened it. That’s what you have today now, fairly managed capital account. Now, the consequence of this is the following.

The consequences of this is largely felt in the form of the property market in China, where property prices have been surging again over the last year or two, mainly because investors have limited options where to put their money, and they were putting it overseas for a while, but now, they cannot. It’s very difficult for them to pull their money and put it overseas. There’s a concern therefore about whether there’s excessive speculation in the real estate market, again, in China. People are not being willing to put it into the equity markets because the equity market has this aura of being not directly linked to the economy and being manipulated, so there is this issue of what do Chinese do because they’re still very large savers and how do they get their money out if they want to, and they can’t get their money out.

If they do, if the government loosens this up, particularly in the face of a trade war, will capital flight reoccur? This is a risk the government has to deal with.

Changing tacts a little bit, China is different in many ways than other emerging economies. While other developing economies and countries have grown as fast, none are as big as China, but other emerging markets have faced similar debt-fueled expansions, right? What are some of the constants across countries and what can China learn from their experiences?

Well, China is focused on a couple of things. It strongly regulates borrowing overseas, because countries which had debt crisis were the ones which borrowed in foreign currencies. Then when exchange rates collapsed, interest rates rose, the debt burden became crushing. The bulk of China’s debt is denominated in RMB. It’s cut off what I call the risks of currency fluctuations and differential interest rates between what is in China and what’s happening potentially in the United States where interest rates are rising. I think the other concern that China has about the debt issue is that the government budget in China is relatively conservative in the sense of the federal government.

The federal government, national government debt indicators ratios are relatively low. Much of the borrowing that’s occurred that’s in China over the last 10 years is by local authorities. What the government has been doing recently is curbing the borrowing of local authorities, which was done through banks and also through the bond market. As a consequence, borrowings of the local authorities in the last year or two have moderated considerably, but at the same time, the local authorities are complaining they don’t have enough money to fund their normal service obligations to their people. That’s what the government is trying to do, to keep a relatively prudent fiscal policy, try to minimize external borrowings and reduce their exposure.

The other issue that China is also learned is — through the Global Financial Crisis – that shadow banking’s sophisticated financial instruments can lead to risks not being adequately addressed. So if you look at the system in the west, which was seemingly the most sophisticated and strongest, yet people did not realize the vulnerabilities, China has been actually trying to address this, but they’re having a hard time doing this because by its very nature, these products and these kinds of shadow banking instruments which have arisen in China are not the same as the ones that we’ve seen in the west. They don’t know exactly what to do about it except to tell the banks to stop issuing these products.

Now, the consequences of this reduction in shadow banking is that funding flows to the private sector firms and households which benefited from shadow banking, that has been cut off dramatically. Some of that demand is what I call sensible demand, but some of it is speculative demand, but speculative demand if it’s regulated moderated is okay too. It’s just a question of making sure that everyone bears appropriate risks of what they’re doing. There is a current situation in terms of funding flows to the private sector activities being squeezed more so than it has been in the past four or five, six years. In a system which is controlled by state banks, which tend to lend to state enterprises , you have this risk that the more efficient or more productive agents, specifically the private companies, may have other access to financial resources curtailed in the coming years, and this is I think a problem.

The problem that you see in other emerging market economies at the lower to middle income level has always been how do you channel funding for infrastructure and other kinds of growth related investment needs? They’ve tended to create development banks, or they support financial projects or borrowings focused on funding infrastructure. This is not a problem in China because the government, since it owns the banks, has been able to steer much of the bank resources to the funding of the infrastructure a lot easier than it is in other developing emerging market economies.

The consequence, however, of this is that the financial situations of some banks who are lending for infrastructure projects, they have a problem in terms of the fact that the returns on these projects tend to be long term and is a credit crunch because local governments and others who are borrowing for these projects, they’re not generating the returns or the revenues are capable of debt servicing. China has this mismatch problem, whereas in other countries, their problem is, “You don’t get enough lending going into these activities.” China in some ways has too much money going into these kinds of activities.

That’s a great point. Yukon, actually if we look at the policy put in place by the Chinese government since last year, they had become fairly aggressive, I will say, in pursuing de deleveraging. We’ve seen some intended and unintended consequences here. The focus seemed to be on controlling liquidity, credit, maturity mismatch vulnerabilities, often posed by less regulated financial activities, but we’re also seeing probably less lending for the private sector and more defaults by private sector lenders. I just wanted to get your take on the deleveraging efforts so far.

Are they maintaining the right balance? Are they asking the right questions?

I think, they’re taking a sensible approach. They realized that the rate of growth of the debt, although it’s not going to lead to a financial crisis, was increasing risks in the system. They were losing control of where this money was going, and speculation was essentially increasing a lot. So they had to send a signal. The signal had to be that the banks and non-banks engaged in this kind of lending need to be held more accountable. Savers who were channeling their savings into funding these activities oblivious of the risks involved need to be aware that there were risks.

It could be bad projects. It could be defaults, and they might lose their funding if they are not careful about diversifying and putting their money into safer investments, but possibly with lower returns. They had to essentially address the question of accountability and risk, and they’ve done that. As you mentioned, the consequence is that there has been an increase in defaults among private firms, but the problem is also felt by local authorities who no longer are able to borrow through local banks and shadow banking products.

They are basically saying they can’t continue providing normal services, and the government has to figure out some way of augmenting their budget without encouraging the return of shadow banking. Now, in the last couple months, the government has basically loosened up a bit. It’s starting to allow local governments to access the bond market, and they’ve asked the banks to fund requests if they can be justified, so that’s helping a little bit. I think it’s the private sector which is harder to address. Now, a large chunk of the private sector funding has been financed by what are called internal savings, funding of households who pool their funds together, and venture funds who amass a small amount of money to fund what I call interesting new technologically potentially technologically sophisticated projects.

There’s quite a bit of money for that kind of activity. I’m not personally too concerned about this. I think it’s something that should happen. It’s good for the system. I don’t think the government’s going to continue to allow what I call the same kinds of practices that have been going on for several years. The issue is can they learn from this and figure out what kinds of regulations make sense? How do they loosen up in the future if they want to without encouraging such speculative activity? This is part of the development of what I call a more sensible financial system for them.

Yukon, we covered a fair bit of ground. It seems you’re relatively sanguine on the level of debt considering where China falls compared to some more developing markets versus developed markets, but a little bit less sanguine on the composition and some of the more structural issues behind that debt. There are a lot of changes going on in China right now, whether it’s demographic changes, social changes, economic rebalancing, the evolution of the regulatory environment. What future developments among these or others that you can think of might possibly change your assessment and where you fall?

China essentially left the easy stage of development. It’s an upper middle income country. It is basically catching up. It’s logical therefore that its growth rate continues to decline, and the issue is that it should be declining gradually and not precipitously. A growth rate of, let’s say, 6.5% now declining gradually to 5% over the next seven or eight years. That’s perfectly fine. What you want to avoid is a sudden collapse so that growth falls to three to four instead of gradually going down to five, and that’s the critical question. Now, what we do know is that this growth cannot be stimulated or supported by continued infrastructure investment as it was in the past.

There are only so many roads that the country needs, so much you can build, so that growth path is no longer possible. That growth path is also supported by very rapid urbanization, so a couple of hundred million people move from rural areas to urban areas. That meant housing, all sorts of services. The pace of urbanization has slowed in China, so that growth stimulator is also being cut off. As you mentioned, this is an aging society. The absolute numbers of workers in the working age groups is declining in China. The only solution alternative in China is as most countries which face a middle income trap issue is can they become more innovative and can they increase the productivity of their workers.

This is where they’re channeling their resources, into research and development, new technologies, automation, robotics. This is where I would say that pressure that is generating what I call the trade and investment wars with America comes from. So here is China trying to become a much more innovative and technologically sophisticated economy. It’s being felt in the west and in America in particular as a threat to America’s strength as the leading technological power in the world. It generates concerns about unfair technology transfer practices, concerns about technology theft, concerns about the fact that China’s so big. It’s a state driven economy, whether this can continue.

I think these are what I call the new issues that are coming up today. That is a challenge for both China and also for the West, and we have to figure out some way that China’s growth process can continue along what I call this more innovative and technologically sophisticated line, but does not necessarily result in these kinds of tensions of the West, which feels that China’s growth is occurring at the expense of the West rather than seeing it as potentially reinforcing process where both sides are better off.

Given that you raised the escalating trade tensions, turning the conversation a little bit back inward towards China and referencing the deleveraging process that we spoke about just a few minutes ago, in this period of escalating trade tensions, do you think that China might feel compelled to stop some of the deleveraging?

Well, it has certainly taken the decision, the tightening up process, which have been going on for about two years now, that needed to come to a halt. You couldn’t tighten any further. If you did, you’re exacerbating what I call the current situation, so they’ve gone from what I call deliberate tightening to what I would call prudent management. They don’t want to encourage some of the pressures which led to the debt acceleration in the past, but they don’t want to choke off funding for absolutely essential expenditures either by local authorities or in the enterprise sector.

Now, they do have the possibility of being able to achieve their goals because one, the major state enterprises who had been suffering a lot in recent years because of their debt problems, they’ve restructured a lot, reduced excess capacity, shed a lot of workers. The rates of return on state enterprises, which have been declining steadily for about seven or eight years, has leveled off and actually started to increase a bit. So that’s reducing the pressures on the financial system. The issue now is with the private sector. The private sector has been pretty good in maintaining relative high rates of return on assets, and even as profit margins have shrunk because of slower growth.

The issue is whether the private sector can continue to succeed and do well under a more constrained financial situation. I think this is the area where the government is monitoring very carefully. If it sees that the industrial production numbers or construction indicators in certain kinds of activities are falling too dramatically, I think you will see the government will actually increase the credit spigots a bit, but until they see that, I think they’re basically in a holding pattern. Not trying to exacerbate the situation, but being careful not to make the debt situation any worse.

It’s important for the government to maintain a good balance and work a fine line, which is quite challenging for policy makers.

Well, at least they don’t have the politics that we have in the United States on that issue. It is a challenge for all policy makers, but there’s a little bit more ability for trying to do this because they have more controls of the system. But even so, it’s more difficult now because China’s economy is so much more complicated. Four or five years ago, the major sources of funding and where that money went into, pretty much, the government could figure it out and do something about. Now, the demands are more complicated and many more kinds of activities have emerged. It’s much more difficult for the government to actually say, “What should we do and what should we not do?”

More complicated situation but then you still have what I call a fairly strong command of the resources in this country so that they can actually do it if they are careful about it.

Well, this has been great, Yukon. You’ve certainly given us and our listeners a lot to think about, so thank you very much.

Thank you.

I appreciate it. Thank you very much. Take care of yourself.

We hope you enjoyed today’s conversation with Yukon. We will continue our deep dive into China’s debt issue in our next episode with Charlene Chu, a Senior Partner at Autonomous Research Asia. Here’s a preview clip from that discussion:

I don’t know that beautiful deleveraging is even possible. It implies that there is a painless exit to this problem and I am of the view that that is not possible. It does not mean that this has to end in a financial crisis. A crisis by no means is preordained here but the idea that China can somehow painlessly exit these problems within the next 10 years I think is just ridiculous…I think we need to see a change in view of the authorities in terms of what is the real sustainable level of growth that we can handle in this economy without relying on huge amounts of excess credit.

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