China's debt problems

The high corporate and local government debt levels in China have sparked concerns about an impending credit crisis in the world's second largest economy. Chinese corporate debt, for instance, is the highest in the world. At the end of 2013, it was estimated by the credit rating agency S&P to be around 14.2 trillion USD.

Furthermore, the easing of the credit conditions following the 2008 global financial crisis and the subsequent boom in construction and asset prices have also triggered talk of the country experiencing a property bubble, whose bust may have disastrous consequences.

Despite all this, Yukon Huang, economist and China expert at the Carnegie Endowment for International Peace, says in a DW interview that China doesn't fit the stereotype of a nation set to undergo a Western-style financial crisis as the indebted companies and banks are all state-owned.

DW: Many analysts argue that the country may be headed for a debt crisis. Are there signs of an upcoming wave of insolvencies of Chinese firms?

Yukon Huang: Many people feel that China is heading for a debt crisis. I believe that the country faces a difficult situation, but it doesn't fit the stereotype of a nation which is set to undergo a debt crisis. China actually faces a problem in the area of corporate debt, which as a share of the nation's GDP is one of the highest in the world.

But it doesn't have any problems in terms of government or household debt.
Even in the corporate sector, most firms in China don't have any issues. The vulnerabilities lie mainly within a small group of large state-owned enterprises (SOEs) which has over-extended and accumulated large debts.

However, these debt problems aren't the same as in the West as these companies are all not only owned, but also backed by either local governments or the national government, meaning that the state is ultimately responsible for the debt. This is why it is unlikely for these SOE's to trigger a cascading debt problem similar to that in Western economies where private companies have a debt servicing problem.

What about the local government debts then?

While local governments borrowed a lot over the past eight years, an audit focusing on their indebtedness concluded that this was not a pervasive problem. And as for the localities which do have issues, either the provincial governments or the central government will have to bail them out.

The key question is whether the central government has the resources to handle the debt problems of some of these corporations and local governments. And the answer is yes. Beijing has almost four trillion USD of reserves and its overall government debt level as a share of GDP is low.

China actually saves more than it invests; it is one of the few countries where the savings rate is higher than the investment rate. Moreover, the country is still generating substantial balance of payments surpluses. China therefore doesn't fit into a stereotype of a country in a financial crisis.

Where did China's current financial problems originate?

The problem in China is that the fiscal system is weak. Local governments therefore borrow from the banking system to fund investments in a host of areas ranging from roads and power plants to health and education. As a result, the banks get involved in infrastructure financing which in turn increases the financial risk. In Western economies, when there is a financial crisis, we think the problem lies in the banking system. But in China, the problem really lies in the fiscal system.

You argue that distorted incentives have spurred the growth of both shadow banking and a property boom in China. What are implications of such factors for the economy?

First of all, every country has a shadow banking sector. But the interesting thing in China's case is that the sector only showed up in the past seven years. Since then, it has become quite significant and accounted for around half of the credit expansion.

But the overall size of shadow banking in China is just a fraction of what it is in other countries. We generally don't consider shadow banking to be a problem in the West. In New York and London, for instance, financial systems are essentially composed of shadow banking; with all the hedge funds, investment banks and trust companies, among others.

But it is important to understand why this sector only came into being a few years ago. The answer to this is that much of the shadow banking is linked to property development and the country did not have a private property market a decade ago.

When a private property market emerges, a lot of credit financing is generated as the market revolves around assets and property development. In most countries, it's a good thing as a nation will not be able to develop a market for assets without it.

But at the same time, it's also new and risky in the sense that people are unfamiliar with the market. So there needs to be more regulatory scrutiny. But the risks associated with shadow banking in China are relatively small compared to the situation in the West.

What impact will these problems have on China's economic growth, which has slowed down in the past couple of years?

The problem is that China is dealing with overbuilding in the property sector. So if the authorities let the market forces play, they have to stop building properties for a year or two and allow the demand to catch up with supply. I would say that China's growth rate should go further down for it to be sustainable, probably close to 6-6.5 percent.

If the government then introduces appropriate reforms, it can probably push growth back up to 7 percent, may be even 7.5 percent, for the rest of the decade and beyond. But that implies the implementation of basic structural reforms as outlined in the third plenary session of the Communist Party's Central Committee.

It is a widely-held belief that China's economy needs to grow at a rate close to 7.5 percent to generate enough employment opportunities. In this context, what impact will a drop in expansion to around 6-6.5 percent have?

It's a strange belief. There are very few countries whose economies can grow at a rate of six percent. And in most economies expanding at a four percent rate, unemployment is a non-issue. So the interesting question is why China needs to grow at 6 or 7 or 8 percent, in order not to have an unemployment problem. The answer is that it simply doesn't need to.

Actually, China has a shortage of labor. Wages have been increasing at an annual 10 percent rate for over a decade. So the issue raised by those - including the government - that China has to grow at such a fast pace due to unemployment concerns is overdone.

The situation in China today is vastly different from that some ten years ago. Back then, state enterprises were shedding workers and at the same time, many were migrating to the cities. As a result, the labor force grew at about four percent a year and the economy therefore had to grow at an annual rate of nine percent to absorb the increasing number of workers.

But today there is no need for such high growth rates due to a shrinking labor force. A five to six percent growth rate should prevent high unemployment and still allow substantial increases in wages.

Yukon Huang is a senior associate in the Carnegie Asia Program, where his research focuses on China’s economic development and its impact on Asia and the global economy.