China’s total debt rose to a record of 237% of gross domestic product (GDP) in the first quarter of 2016 and now exceeds that of its Emerging Market counterpart, India.
In the first quarter alone new debt increased by 6.2 trillion renminbi, marking the biggest three-month surge on record and a 50% increase over last year’s pace.
Even with the backdrop of mounting debt, the Chinese economy has managed to meet its economic growth target of ~7%. But, a closer look reveals that overall credit grew much faster than nominal GDP in the last year, resulting in an excessive debt burden for the economy.
What Led to Mounting Chinese Debt?
In order to keep the economy chugging along, the government embarked on a credit crusade following the financial crisis. This raised China’s total net debt to $25 trillion renminbi by the end of Q1 2016 (including both domestic and foreign borrowing). The problem is that it never stopped borrowing.
In the beginning of 2009, new loans grew by 95%, but following the financial crisis the government started offering cheap credit to a number of companies to build apartments for urban migrants, airports for the newly affluent and roads to accommodate a fleet of new cars.
This, in essence, is what led to loan growth at twice the rate of gross domestic product. The spigots have remained open, and bad loans are said to have doubled in the past two years and now represent 5.5% of banks’ total lending. Interest on existing loans has also mounted to the point where borrowed money is needed to finance payments due. It’s been reported (in the Economist) that in 2014, 160 of the 1,000 largest Chinese firms owed more in interest than they earned before tax.
Bottom line for Investors
Many economists are of the opinion that while the size of country’s debt is a serious concern for the global economy, more worrisome is the speed at which it has accumulated. History shows, in many cases, that major economies that experience rapid increases in debt-to-GDP ratios have suffered either a financial crisis or a prolonged slowdown in GDP growth.
Chinese policymakers are saying they recognize the problem and that necessary steps are being taken, but if a global slowdown or recession mixes with the wrong kind of policy it could mean some kind of judgment day. Even if the People’s Bank of China is able to safeguard the economy from such an event—which they’ve been able to do so far—long-term high debt levels could result in a Japan-style slowdown and recession that would drag on for decades.
The fact that China had been able to overcome, through growth, from a similar problem a decade ago gives a glimmer of hope. But, the government would be well-served to take aim at more structural solutions to the problem versus short-term solutions like debt-for-equity swaps and loan rollovers. Those are Band-Aids that simply won’t hold for long in the current scenario. It’s a problem world governments and investors alike should keep an eye on.
Disclosure