Why Hasn’t China’s Credit Crisis Exploded?

06 Apr 2017

People who lean on logic and philosophy and rational exposition end by starving the best part of the mind. – William Butler Yeats

  • Recent research, including by the Bank for International Settlements (BIS), warns again that China’s private-sector credit growth had accelerated to a potential crisis point.  In fact, the BIS raised a similar warning in 2012.
  • Yet China’s “credit bomb” has not gone off despite decades of expert warnings.  Many China analysts have often failed to appreciate the fundamentals behind China’s debt dynamics which are much more stable than many countries.
  • China is still many years away from a potential debt/banking crisis for some good reasons.  The true concern is whether Beijing is entering into a “Faustian bargain” that trades short-term gains of limited economic growth today with long-term pains of diminishing investment returns tomorrow.

China’s debt problem does not stem from the household and public sectors (they stood at 35% and 44% of GDP, respectively, in 2015); it stems from the corporate sector.  BIS data shows that China’s non-financial sector debt grew at an annual rate of 18.1% between 2010 and 2015 to more than 160% of GDP, a level that was even higher than in the US.  While state-owned enterprises (SOEs) were the major borrowers, many private-sector property developers were also among the highest leveraged Chinese companies.

China’s private-sector debt

Many analysts associate China’s private credit with corporate debt and a recent market study[1] defines China’s total private credit as bank credit plus corporate bonds.  It argues that China’s private credit had grown larger than that of the EU’s and that the situation had gone out of proportion since China has much lower per-capita income than the EU.  However, this commonly-used definition of China’s private credit is wrong.

About 60% of Chinese corporate bank loans are extended to the SOEs and about the same share, if not more, of the so-called corporate bonds are issued by the local governments and their financing vehicles.  True private-sector credit, as approximated by bank loans to the small and medium-sized companies, has been stuck at around a third of total bank lending, despite the official rhetoric to expand private-sector loans (Chart 1).  The share of private credit is higher if one includes shadow bank lending, and this is where the true financial stress lies; but it is not yet fatal.

The problem with analysing China’s corporate debt is that many analysts have confused its private-sector obligations with public-sector debt; and the definitions are indeed iffy.  In China, a large share of company borrowing that is often counted as private sector, including by the BIS statisticians, is actually lending to the SOEs and their affiliates that enjoy implicit guarantees.  These are not really private debt.

One may argue that debt is debt and it does not matter whether it sits on the private- or public-sector’s balance sheet.  However, the distinction is crucial when it comes to assessing the risk of systemic defaults.  These are far less likely when the bulk of the debt is owed by the public sector that has a strong balance sheet, as is the case in China.

Mind the credit gap

The BIS’s data also shows that China’s corporate debt had risen above its long-trend by 30% of GDP in 2015, creating a large gap between actual and trend growth.  Its research[2] argues that a credit gap of more than 10% of GDP would sharply increase the odds of a country’s financial crisis.  However, one should allow for the implicit guarantee distortion in most “private” debt when assessing China’s credit problem.

Even if one accepts the BIS’s estimate at face value, the credit gap is not a reliable crisis predictor.   There were countries that fell into a financial crisis with a credit gap of less than 10% of GDP, such as the UK (with a credit gap of less than 10% in the years before the 2007-08 Great Financial Crisis) and South Korea (with a gap of only 5% of GDP in the run up to the 1997-98 Asian Financial Crisis).  On the other hand, some economies avoided a financial crisis with a credit gap of more than 10% of GDP, such as Australia in the years around 2006 and Hong Kong around 2011.  One can find reasons for why these economies escaped a financial crisis while the others did not, the point remains that the credit gap is not a reliable predictor of financial crisis.

[1] Garcia-Herrero, Alicia (2017), “”Vertigo!”: China Ballooning Credit”, Natixis China Hot Topics, 10 March.

[2] See Drehmann, Mathias and Kostas Tsatsaronis (2014), “The Credit-to-GDP Gap and Countercyclical Capital Buffers: Questions and Answers”, Bank for International Settlements, 9 March.

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