Some observers argue that China’s debt-to-GDP ratio, estimated at close to 250% in 2015, has reached a point that could soon trigger a systemic collapse.
This ratio is high by international standards, but not excessively high. It ranks only in the middle of the world debt league, according to Bank for International Settlement’s data, with countries such as Japan, Belgium, Portugal, Ireland, the Netherlands and Greece recording significantly higher debt ratios.
How much is too much?
Debt arises when an economy transforms its savings into investment. If all national savings are transformed into investment via the equity market, the economy incurs no debt. In reality, there is always a portion of national savings being transformed into investment via borrowing either through bank loans or bond issuance.
In a closed system, given a stable structure of financial intermediation between equity and debt financing, the higher the national savings the higher the level of debt. So debt is bound to arise and there is nothing good or bad about it. Empirical evidence shows that there is a positive relationship between a country’s national savings and its debt level. China ranks high on the chart due to its high national savings (50% of GDP).
However, in an open system, a country can borrow foreign savings from abroad, and build up a debt stock larger than its stock of domestic savings. Generally, debt financed by borrowed savings is more susceptible to instability than debt financed by domestic savings.
In China’s case, it only has a small (less than 15% GDP) foreign debt. It also has a net international investment position. Its debt is mostly domestically-financed and is denominated in local currency. Its capital account is still relatively closed.
Thus, China’s debt is likely to be more stable than that of other countries which have similar or even lower debt ratios. Its high debt load is a reflection of its high savings, the bulk of which is intermediated through the banking system. This brings us to the structure of the financial system, which can affect a country’s debt level.
A different financial structure
The US has a deep and highly liquid equity market, which has long been a key form of capital allocation in its economy. In China, debt financing (including mostly bank and shadow-bank loans) accounted for 95% of its total financing in 2015, while equity financing accounted for only 5%. An under-developed equity market suggests that China’s growth would have to be funded by debt.
So China’s debt ratio may not be as excessive as it seems due to its financing structure. However, this does not mean that China does not have a debt problem. Pessimists argue that a debt-currency crisis would result soon. They may be surprised. This is because China’s debt is structurally different from that of the crisis countries. China’s very small foreign debt, abnormally high domestic savings, under-developed financial system, implicit guarantee policy and closed capital account have acted as a 'shield' that protects the Chinese system.
This is not to deny China’s debt problem. But the presence of the 'shield' means that no one can easily pull the plug on China’s financial system. It helps buy time for Beijing to sort out the debt problem through structural reforms. It is likely, in my view, that Beijing’s recent policy shift towards boosting GDP growth would stabilise the economy but at the cost of a rise in the debt-to-GDP ratio and slower structural reforms.
Beijing is facing a dilemma of structural adjustment racing against GDP growth. Opting for a 'shock therapy' would risk killing the economy before giving structural reforms a chance to succeed.
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This article was first published in the Weekly Intelligence Report on 24 May 2016.
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