The rapid rise of China’s internal debt stock is a global concern. Oxford Economics research shows that non-financial sector debt has soared to 250% of GDP in 2015, due mainly to a very high investment ratio alongside falling corporate profitability. Debt-to-asset ratios look worrisome in problem industries and real estate. Problem loans could be 10-15% of GDP now and might rise to systemically critical levels if the credit boom continues.

Kuijs, Louis (2016), “China’s rising debt – how will this evolve”, Oxford Economics, Research Briefing, May 2, 2016.
There is no free link to the briefing. For a copy please contact Oxford Economics.

This post ties in with our summary page on systemic risk in Emerging Markets and China.

The below are excerpts from the research. Headings, links and cursive text have been added.

The size of China’s domestic debt

“Total debt of the non-financial sector of households, corporates and the government…reached 250% of GDP at end-2015. That is lower than the average of advanced countries of 258% of GDP but substantially higher than the emerging market average of 175% of GDP. Moreover, what worries many observers most is the rapid increase since 2008. Credit surged as part of the stimulus plan during the global financial crisis but debt has continued to rise fast ever since.”

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“Corporate debt is by far the largest portion at 145% of GDP at end-2015. It also rose the fastest in recent years.”

The causes of rapid debt growth

The key reason why debt has swelled since 2008 is to finance an increasing share of very high investment levels…Since the late 1990s, investment has risen as a share of GDP, especially in 2009 when it jumped 5%-points of GDP…To achieve investment of 44% of GDP, given the current composition of investment a flow of 26% of GDP in new credit was needed in 2014 and 2015.”

“However, the amount of new credit “required” per unit of investment has also increased over time…This ratio rose gradually from 44% in 2002 to 53% in 2008 and then…around 60%….About 70% of the rise in the stock of adjusted total social financing in 2008-15 was to finance the investment in this period given 2008 ratios of external financing, and 30% was because the required amount of credit per unit of investment has risen.”

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“The main reasons [for greater reliance on debt financing of investment] have been a greater need for external financing in the corporate sector because of lower profitability, more intra-corporate lending and rising leverage of real estate developers.”

“High savings obviously matter. Gross domestic saving of around 47% of GDP in 2015 exceeded investment…With high saving and capital controls, financial surpluses have to be channeled by the financial system to other parts of the economy….However, while high saving allows for rapid credit growth without relying on volatile foreign capital, changes in the gross domestic savings to GDP ratio cannot explain the evolution of the credit to GDP ratio in the last 15 years.”

The weakest links

“With gross fixed capital formation of around 44% of GDP in 2015, physical capital continues to accumulate rapidly. With a physical capital-output ratio of around 3.2 and 5% depreciation, the capital stock grew 9.2% in 2015… amid structural overcapacity inn key industrial sectors and high inventories of unsold housing, it is important to investigate the quality and productivity of capital, as this determines the capacity to service debt.”

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“Overall, rates of return on assets in industry are still reasonable, although they have been coming down since 2011, especially in state-owned enterprises. Interestingly, debt-to-asset ratios in industry have on average fallen. Thus, when we say that China is leveraging up, it is because credit is rising as a share of GDP, even though corporate balance sheets on average do not seem to become more leveraged in terms of debt to asset ratios, because saving and investment are also very high in relation to GDP.”

“But these averages hide important differences across sectors. In industry, the main problem sectors are coal mining, steel and other metals. They exhibit low and falling rates of return on assets and high and rising debt-asset ratios… These financial indicators are also problematic in the real estate sector (property developers) and (a bit less so) in construction.”

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The potential size of bad debt

“We estimate that at end-2015, total debt outstanding in coal mining, steel and other metals was equal to 11% of GDP. Debt in the real estate sector was a whopping 45% of GDP and in construction it was 12% of GDP. In all, debt in these sectors with problematic financial indicators was 68% of GDP at end- 2015, or 27% of the total.”

“To get an idea of the possible scale of necessary write-offs, we assume that in coal mining, steel and other metals 25% of debt will eventually go bad, in real estate 12%, construction 8% and in the rest of the economy 2.5%. That would lead to a total amount of bad debt of 13.6% of GDP.”

“While 13.6% of GDP is a big number, the actual loss after recovery tends to be lower and the costs can be spread out over time…The total costs of China’s bank restructuring of the early 2000s were around 22% of GDP… Moreover, much of the lending and borrowing has taken place within the wider public sphere, allowing the government to take on a coordinating role at times of stress.”

“These numbers relate to the level of debt at end-2015. Unfettered credit growth along the current lines in the coming years would rapidly expand the bad debt problem and the associated costs of a restructuring … For policymakers, ambitious growth targets are the key policy objectives for now and deleveraging is not really on the radar screen…While…a sudden systemic financial crisis [is] unlikely for now, continuation of the relentless rise in debt raises the risks of financial market turmoil.”

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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. At present he is head of research and quantitative strategies at Macrosynergy Partners.