Mainland China’s Authorities Admit Rising Bad Debt Risks

Kristian Rouz — People's Bank of China's (PBOC) vice-governor Chen Yulu admitted on Sunday previous reports that the nation's financial institutions are facing increased risks to their stability and performance stemming from excessive credit expansion in the previous years. A massive amount of non-performing loans, as well as indebtedness of risk-exposed industries such as stock market operations, is the main concern right now. Chen's commentary surprisingly lines up with recent notes made by US billionaire investor George Soros, who voiced concern on China's burden of commercial and provincial debt.

PBOC's Chen said during his speech at a financial forum in Hangzhou on Sunday that threats to financial market sustainability are rife due to significant debt imbursement fueling the mainland's economic growth over the past several years, as reported by Shanghai Securities News. In order to address the emerging challenges, Chen said, the PBOC is working towards enhancing the capabilities of monetary policy regulation, including through the elimination of supervisory loopholes.

According to several recent reports on mainland China's credit expansion, in Q1 new loan issuance surpassed $1 trln, ensuring a less dramatic slowdown of the broader economy, to just 6.7% from a year ago. The Chinese growth had been 6.9% throughout 2015, and if not for debt imbursement, the current slowdown might have been steeper, albeit less risky. China's economy is now at its slowest pace of expansion since 2009.

However, instead of providing a boost to domestic manufacturing and services, a lion's share of these new loans went into the property market, resulting in a massive surge in real estate prices, in particular, in the financial hub of Shanghai, and the industrial powerhouse of Shenzhen. The current property market situation is reminiscent of that seen in China in 2013, potentially threatening to end up in an asset bubble.

Subsequently, if worst comes to worst, mainland China's economy is facing two potential scenarios: a domino-effect debt crisis similar to that in the US in 2008, or a disinflationary trap reminiscent of that in Japan since early 1990s.

"Every major country with a rapid increase in debt has experienced either a financial crisis or a prolonged slowdown in GDP growth," Ha Jiming of Goldman Sachs said.

The mainland's total debt now amounts at 237% its GDP, according to some estimates, with all debt insured by the central government in Beijing. That is far above other emerging markets indebtedness, which stands at an average of 175% GDP, according to the Bank of International Settlements' (BIS) data. Yet, the BIS calculations put mainland China's total net debt at 249% GDP, compared to that of 248% in the US, and 270% in the Eurozone.

While select advanced economies, namely, the US and the Eurozone, might be even deeper in debt at this point, China's export-reliant economy is lacking structural sustainability allowing for greater debt capacity.

According to Financial Times estimates, mainland China's net debt stood at $25 trln in late March, including both domestic and external borrowing. Such a situation, as warned by the International Monetary Fund (IMF) recently, poses a menace of rife spillover effects to advanced economies involved in mutual trade with mainland China.

In Q1 mainland China borrowed 6.2 trln renminbi, or roughly $1 trln, adding some 15% to its total debt from a year earlier. That, compared to GDP growth of 6.7%, puts the very health of the Chinese economy into question.

Unlike most other economies, the lion's share of China's debt is corporate, at roughly 175% its GDP compared to that of 70% in the US, 100% in Japan, 100% in the Eurozone, 75% in advanced economies, and just 25% in emerging markets as a whole. Most of the advanced nations' debt is household and governmental borrowing, whilst in emerging markets general household indebtedness is the largest part of total net debt, according to BIS data.

A crisis, however, might be averted, but at the expense of growth in the longer-term. Japan's staggering volume of debt, most of which is domestic, only resulted in disinflation and a lack of economic expansion lingering for over two decades, without any economic meltdown drama. The Japanese scenario might be the likeliest possibility for China at this point as long as the government in Beijing is able to maintain the situation under control, which, given the vast ‘grey economy' area and significant role of shadow banking in the economy, might be increasingly difficult over the coming years.

Should certain banks turn out to be unable to finance their liabilities, including due to the mounting non-performing loans burden, a financial crisis would be a matter of time. That said, adequate policy and regulative response from Beijing is vital at this point, as the debt-fueled growth model has not provided the desired acceleration to the nation's economy anyway.