According to the latest IMF China report credit to non-financial institutions has soared to over 230% of GDP, an increase of 60%-points and a doubling in nominal terms from 2011 to 2016. Credit efficiency, i.e. the benefit of new lending in terms of economic output, has deteriorated markedly. Corporate lending has soared with an outsized allocation to state-owned enterprises, particularly to “zombie” and overcapacity firms. The credit boom has been supported by an abnormally high national savings rate of over 45% of GDP, which is likely to decline going forward. Historically, almost all credit booms that were similar to China’s in size and speed ended in a major downturn or credit crisis.

International Monetary Fund, “People’s Republic of China – Selected Issues”, IMF Country Report No. 17/248, August 2017.

The post ties in with SRSV’s lecture on financial system risk in emerging markets.

The below are excerpts from the IMF report. Emphasis and cursive text have been added.

Key facts

Nominal credit to the nonfinancial sector more than doubled in the last five years, and the total domestic nonfinancial credit-to-GDP ratio increased by 60 ppt to about 230% in 2016. As a result, the credit gap—deviation of the credit-to-GDP ratio from its historical trend—is currently about 25% of GDP.”

“The narrowest measure is banks’ claim on the private nonfinancial sector, which stood at about 155% of GDP as of 2016. Total social financing statistics capture not only conventional bank loan channels but also financing through off-balance items of financial institutions—trust loans, entrusted loans, and undiscounted bankers’ acceptances—and corporate bond issuance. As of end-2016, total social financing [to the private sector] was about 209% of GDP, of which households accounted for about 44%…Total domestic nonfinancial sector credit [including the government sector] is estimated to be about 234% of GDP.”

N.B. According to the BIS data total credit to the non-financial sector in China even reached 257% of GDP at the end of 2016, compared with an average of 184% for emerging market economies and 264% for advanced economies.

Credit efficiency has been deteriorating, pointing to increasing resource misallocation. Credit to certain sectors (industrial), firms (state owned enterprises), and regions (Northeast) is significantly higher than their value added, suggesting that they use credit relatively inefficiently. In 2007-08, new credit of about RMB 6½ trillion was needed to raise nominal GDP by about RMB 5 trillion per year; in 2015-16, it took RMB 20 trillion in new credit…Sustainable growth—growth that can been achieved without excessive credit expansion—was likely much lower than actual growth over the last five years.”

“Banks’ rapid asset expansion has relied on increasingly complex funding structures, extending beyond deposit funding to interbank markets and wealth management products, and via complex and interlinked networks of entities. Asset managers often finance illiquid long-term investments by rolling over short-term funding or pooling investment funds. Complex funding structures and sizable, opaque off-balance sheet investments suggest that a deleveraging process in the financial sector could be bumpy.”

The corporate credit issue

State-owned enterprises are at the center of China’s high and rising corporate debt. Many of them are nonviable “zombie” firms and in overcapacity sectors…Nonviable “zombie” firms are those whose liquidation value is greater than their value as a going concern, taking into account potential restructuring…As a group, these companies account for an outsized share of total corporate debt and have contributed to much of the its increase in recent years.”

“Overcapacity sectors are those that suffer from low capacity utilization rates and persistent losses. Although overcapacity firms contributed moderately to the rise in corporate debt during 2008–16, they are estimated to account for 10–15% of total corporate debt. While profitability has improved since late 2016, their share of total corporate debt has remained high.”

While state-owned enterprises account for declining shares of industrial output (from over 40% to about 15-20% over the last 15 years), they have an outsized share of corporate debt (57% of total corporate debt or 72% of GDP in 2016) and contributed to almost 60% of the rise in total corporate debt during 2008–16. SOEs underperform private firms on average, with lower returns and productivity (IMF 2016). Productivity was also 25% lower than that in private firms on average, controlling for industries.”

The savings issue

“China has one of the highest national savings in the world…After China’s integration into the global trading system with WTO entry in 2001, savings surged to peak at 52% of GDP in 2008. Since the Global Financial Crisis, they have gradually come down to 46% in 2016. However, despite the moderation, China still stands out with one of the world’s highest savings rates, compared to the global average of around 25% of GDP.”

At 23% of GDP, China’s household savings today are 15%age points higher than the global average… The one-child policy, introduced in late 1970s, has led to a rapid decline of the fertility rate from 6 to below 2 and resulted in an extremely low youth dependence ratio in China given its income level. Such demographic changes have increased household savings via two channels: a) less spending on children on the expenditure side; b) higher precautionary savings for retirement as fewer children imply less old-age support, which is the main source of livelihood for the elderly in China.”

“The economic transition of the 1980s/90s led to the breakdown of the social safety net and rising savings, a trend that recent policy efforts have aimed to reverse.…In many countries, the savings rate for the bottom 10-20% is often negative, reflecting substantial social transfers, while in China, the savings rate is positive and quite high at 20%. This likely reflects the lack of social transfers, inadequate progressivity in taxation, and the limited social safety net.”

“Excessive savings when kept domestically are often intermediated through the financial system and can fuel a credit-based investment boom. After the Global Financial Crisis, while China’s external imbalance declined (with the current account surplus down to 2% of GDP), it morphed into a growing internal imbalance. Savings have financed excessive investment with falling efficiency, resulting in slower economic growth and a rapid build-up of debt.”

The risk of crisis

“International experience suggests that China’s current credit trajectory is dangerous with increasing risks of a disruptive adjustment and/or a marked growth slowdown. We identify 43 cases of credit booms in which the credit-to-GDP ratio increased by more than 30%age points over a 5-year period. Among these, only 5 cases ended without a major growth slowdown or a financial crisis immediately afterwards. However, considering country-specific factors, these 5 country provide little comfort [1]…In addition, all credit booms that began when the ratios were above 100%—as in China’s case—ended badly.”

[1] “The credit boom in New Zealand (1992) was due to a one-off credit expansion in 1988 from a low base. A boom in Hong Kong SAR (1983) should be seen in the context of its role as a global financial center. A boom in Finland (2003) was the result of economic recovery after large deleveraging in late 1990s. Credit booms in Indonesia (1990) and Switzerland (1985) eventually led to crises after further credit expansion.”

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Ralph Sueppel is founder and director of SRSV Ltd, a research company dedicated to socially responsible macro trading strategies. He has worked in economics and finance for almost 25 years for investment banks, the European Central Bank and leading hedge funds.