What We Don’t See in China’s Debt Risk

12 Oct 2017

Look up at the stars and not down at your feet. Try to make sense of what you see, and wonder about what makes the universe exist. Be curious. – Stephen Hawking


  • China’s credit growth has risen rapidly from less than 150% of GDP in 2008 to an estimated 260% of GDP in 2016, with the bulk of the increase coming from the corporate sector.  Mortgage debt has also soared and is seen as a potential new trigger for the “debt bomb”.
  • Conventional analysis only focuses on the problem of diminishing marginal efficiency of credit in China.  However, it has missed the impact of financial deepening on boosting the system’s debt-to-GDP ratio but not necessarily making credit unproductive.
  • China is going through financial deepening and the sharp rise in mortgage debt is a result of this process.  Concluding that all the increase in China’s debt-to-GDP ratio reflects worsening credit quality overstates the true debt risk.

Further to my recent argument that the debate on China’s debt risk had been partial (by focusing predominately on the liability side of the economic balance sheet and missing the asset side that has positive growth implications from debt accumulation), here is another side of the debate that the market has missed – financial deepening. This refers to a process that increases the provision of financial services to economic agents in the system at any given level of GDP. It includes the development of financial markets and an increase in the number of financial institutions providing diversity in financial instruments.

The conventional wisdom

A rapid increase in debt relative to GDP growth leads to diminishing marginal efficiency of credit as each unit of credit increment produces a declining amount of output. Much of this unproductive credit will eventually turn into non-performing loans (NPLs) when borrowers cannot generate enough revenues to service their debt. The NPL problem may be hidden when GDP growth is strong, but will emerge and inflict losses in the system as growth slows.

Furthermore, as in China, when fast debt accumulation is accompanied by financial innovation, which includes a proliferation of new financial players and instruments creating multilayer lending and regulatory arbitrage, systemic risk becomes bigger and harder to regulate. Arguably, this was what happened in the US in the years before the subprime crisis, with the rise of poorly-understood securitised loans spawning into a diversity of leveraged products. Arguably, something similar is happening in China, with the rise of shadow banks (including non-bank financial institutions) as conduits for disguising loans as “investments” that require less capital backing and are exempt from NPL provisions.

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