China’s corporate debt has climbed to levels that, in other countries, have led to financial crises.
But the debt-for-equity swap program Beijing adopted this year will not solve its problems, and China will not be able to grow itself out of trouble again.
The Chinese government will have to either sacrifice growth and political capital to reduce its mounting debt or risk a banking crisis.
China will enter the New Year under the shadow of looming economic and financial risk. Since the global financial crisis began in 2008, the Chinese economy has amassed a massive amount of corporate debt that, when seen to the same extent in other countries, has signaled treacherous times ahead. China is no stranger to ballooning debt, and it encountered similar problems at the turn of the century. Now Beijing is trying the same remedies it used before, but the circumstances it faces today are different than those it saw 15 years ago. Because China’s economy is more controlled than most, Beijing has more room to influence it than Western countries have had in their own economies when faced with similar issues. But any action China takes will only put off its problems, instead of fixing them for good.
China’s corporate debt has been growing steadily for years. After relying on exports for economic growth prior to the 2008 crash, Beijing has since filled the gap left by slumping demand for its goods by encouraging domestic investment, particularly in the construction sector. Over time, this investment has led to increasing inefficiencies and diminishing returns, saddling China’s large steel companies with debts too big to service. In September, the Bank for International Settlements released new statistics on countries’ credit-to-GDP ratios, its preferred indicator for impending debt crises. Any score over 10 suggests a country is at greater risk of suffering a debt crisis in the next three years; China scored 30.1. And of China’s total debt, the vast majority is owed by corporations.
A familiar approach
With corporate debt now standing at 169 percent of GDP, China has a mountain of IOUs to pay off. This year it has taken steps toward doing just that, and in the fourth quarter Chinese companies began trading in their debt for equity, mimicking the approach Beijing took to rectify similar debt issues in the late 1990s. But these are not the 1990s, and there is no guarantee that the revived swap program will have the same effect this time around.
China emerged from the Asian financial crisis in 1998 weighed down by a slew of nonperforming loans; official estimates put them at around 30 percent of the country’s total loans, while unofficial figures put them above 40 percent. Beijing’s solution was to set up asset management companies to buy some of these bad loans from state-owned banks, erasing them from lenders’ balance sheets and freeing state-owned enterprises from their debt burdens. The key to this scheme was where the money came from and how much the loans were discounted: Normally, the fact that the loans are nonperforming makes them less valuable, so the closer their sale price is to face value, the worse the deal is for the buyer. However, bigger discounts also make debtors less comfortable with the sale. In 1999, asset management companies bought bad loans — using funds from the People’s Bank of China — at face value, taking on all of the losses attached. And so, state money bailed out China’s ailing institutions and taxpayers took the hit.
This arrangement was problematic, perhaps most of all for the moral hazard it created. Sure enough, Chinese banks soon began to lend to the same struggling firms, and it seemed as though it was only a matter of time before Beijing found itself in another debt crisis of its own making. But the government managed to avert disaster, thanks in large part to the economic growth spurt China saw between 2002 and 2008 as the newly formed euro area and loose U.S. monetary policies fueled an insatiable demand for Chinese products. Since China’s entry into the World Trade Organization in 2001 had lifted many of the barriers to its cross-border trade, the country was able to grow out of its financial health problems.
This year, Beijing has tried to learn from its mistakes. The newest version of its debt-for-equity swap program is much more market-based than its predecessor: Debt values are now set by the market, rather than by their face value. Moreover, the current program is intended — at least in theory — to swap only the good loans instead of the bad. Putting this in practice should be made easier by the fact that, according to official estimates, nonperforming loans amount to only 1.75 percent of China’s total loans, as opposed to 30 percent in 1999. Still, that figure may sound too good to be true because it probably is: The International Monetary Fund says Chinese “loans at risk” range between 10 and 15 percent, while some analysts say they might reach as high as 22 percent by year’s end.
This could point to a fundamental flaw in the new program: If it truly is to be financed based on market principles, then any buyer should be able to sniff out bad loans and steer clear, regardless of whether their unsuitability is reflected in official statistics. This could then undermine the entire program, forcing Beijing to lean on prospective buyers or use government funds to ensure that transactions take place.
In truth, this probably will not happen since the program is still fairly small, at least compared with the gargantuan debt problem it is designed to address. As it was initially set up, the program will only tackle $400 billion or so of China’s $17 trillion in corporate debt, likely relying on capital from unsuspecting retail investors and possibly on government cash funneled through state-owned banks. Either way, it is unlikely to make much of a dent in how much Chinese firms owe.
For a state-owned problem, a public solution?
The market will not solve China’s oversized debt issue. Though Beijing has taken steps to liberalize its economy in recent years, most roads still lead to the state. It is no coincidence that the bulk of China’s debt is owed by state-owned companies to state-owned banks. Aware of this reality, Beijing might be tempted to return to the age-old method of throwing money at the problem. But there are pitfalls in taking this path, too.
First and foremost, public funds did not actually resolve China’s financial troubles in 1999. The real remedy was the surge in global demand that fueled China’s double-digit growth. An outright bailout now would run the risk of reviving the moral hazard that arose nearly two decades ago, potentially leaving Beijing throwing good money after bad.
Furthermore, today’s problems exist on a much larger scale. China’s GDP amounted to $1 trillion in 1999; now it is 10 times bigger, while the country’s debt is nearly 20 times bigger. Of course, not all of China’s debt has to be settled. Most of its loans are still healthy, and according to Standard & Poor, Chinese banks need only $1.7 trillion or so in capital. The question is, where would that money come from? If Beijing wanted to, it could borrow the funds to recapitalize its banks, as many Western countries did after the 2008 banking crisis. At first glance, China’s public debt is a manageable 44 percent of GDP, which is not far from the emerging market average of 40 percent and would allow some room for growth if need be. But a closer look shows that these figures are more complicated: China’s official debt-to-GDP ratios do not include the debts of local governments, which are responsible for about 80 percent of government spending. If they were factored in, China’s public debt would be closer to 90 percent of GDP, placing it up near developed countries in terms of indebtedness and limiting its room to maneuver.
In theory, China could try to inflate away its debt by printing more money, as European governments did after World War II. But that would simply shift the burden onto Chinese citizens, a move that would be deeply unpopular at home and abroad — other countries are already accusing Beijing of manipulating its currency. It would also undermine China’s own effort to shift its economy toward one based on consumption by eroding the public’s purchasing power and weakening the yuan, which Beijing has been propping up for the past 18 months.
China has substantial foreign exchange reserves on hand ($3.06 trillion, to be exact). Many have pointed to these reserves as a potential rainy day fund that could be tapped if the situation becomes dire. But again, it would not be so simple. Foreign exchange reserves are not typically used to recapitalize banks, though China already proved itself the exception to this rule in the early 2000s. More important, these funds are already tied up in another cause: bolstering the Chinese currency. After the value of the yuan spiked in 2014, China began to loosen its peg to the U.S. dollar, allowing its own currency to start depreciating once again. Beijing has stepped in to manage its decline, taking care not to let its currency enter into a free fall and trigger a panic. By spending $1 trillion in foreign exchange reserves, Beijing has been able to buoy the yuan somewhat as it slowly depreciates, putting a sizable chunk of its spare cash toward reassuring the markets of its currency’s reliability. But the real price of maintaining that reassurance is difficult to quantify.
Clearly there are no easy answers to China’s debt problem, which is looking grimmer by the day. The only painless escape would be on a wave of economic growth, but at this point that seems unlikely. Achieving growth rates of more than 10 percent is much more difficult for an economy that is already the second-largest in the world, and the global economic environment is not half as favorable to China as it was 15 years ago because the developed world is struggling to manage debt problems of its own. At home, Chinese wages are considerably higher than they were in 1991, and the economy is less competitive. Because China’s working-age population will soon begin shrinking, ending the productivity gains from the decadeslong “demographic dividend,” these wage hikes will make it harder for the country to achieve prodigious growth.
Instead, Beijing appears to be on the verge of making a difficult choice: Sacrifice growth (and by extension, political support) to tackle Chinese debt head-on, or risk suffering the same debt-driven banking crisis seen in so many countries.