Pandemic test for China's debt

I don’t usually argue that China has a debt crisis. Rather I say it has massive over-indebtedness (particularly among state enterprises and local governments) and this threatens to slow growth rather than cause a crisis. Much of the debt is owed by state entities to state-owned banks, and the authorities can manage it without causing a panic.

But the pandemic’s impact on economic growth, with the Delta variant now threatening a new economic slowdown, is creating strains. Q3 GDP now looks likely to be flat, or even down, as widespread local lockdowns impact on supply chains and services delivery. And debtors’ problems are coming up against the authorities’ efforts to limit a further rise in debt and instil a credit culture.


Debt has supported growth

Economic growth has been boosted in recent years, even before the pandemic, with steadily rising government and household debt in relation to GDP. Corporate borrowing, mainly by state enterprises, soared after the Global Financial Crisis and has been fairly stable at high levels since then. But government debt including local authority debt has been rising, and is now pushing 90% of GDP, a high level for an emerging economy. Meanwhile household debt is no longer low, one reason why the government is keen to control the property sector tightly (see table).


Gradually allowing more defaults

Over the last 5-6 years the government has allowed progressively more defaults on bonds, including state enterprise bonds, in an attempt both to avoid the cost of a bail-out and to make clear to investors that the government will not always stand behind them. The government has also improved the bankruptcy process so it is more open and fair to creditors than it used to be. But the pandemic simultaneously hits cash flows across the economy, making debt harder to service, while creating pressure for more fiscal spending to mitigate the economic impact.


Stress is building

News of stress continues to build. Huarong, a state-owned distressed debt manager with more than $40 bn in debt, originally set up to deal with banks’ bad loans in the 1990s, has been struggling again recently, after reportedly receiving government help in the spring. Evergrande, the country’s second largest developer, with debts of more than $100bn, reportedly has its bonds valued at a significant discount in Chinese markets. Another developer, China Fortune Land, defaulted on a $530mn bond last February.


The Economist noted this week that the government has apparently backed away from a plan, mooted in July, to restrict bank lending to troubled Local Government Financing Vehicles (LGFVs). LGFVs are a key way for China to deliver infrastructure investment. And deliver it they have with China enjoying by far the most advanced infrastructure of any emerging country. This has been a great support for economic development but it has also artificially inflated economic growth figures since infrastructure spending counts towards GDP. The trouble is that there are a lot of white elephants and many LGFVs cannot pay interest without further bank loans.


So far, no LGFVs have been allowed to default but their total debts are reportedly US$ 7.5 trillion, 50% of GDP, of which just less than a quarter are securities. A default in this sector could send shock-waves through the credit markets.


In fairness, this may be the point. The authorities are desperate to rein in expanding debt and get that credit culture going. Allowing, or threatening to allow, entities with presumed implicit government support to go under is the only way to do so. The danger is that introducing moral hazard, a laudable intention, leads to a panic. That’s what happened with Lehman after all.


Expect a further gradual economic slowdown

I still think the government will be able to manage this process. By gradually allowing more defaults, including among the weakest LGFVs at some point, it will force investors to be more selective, without leading to a general panic. And when there are mini-panics, it will step up enough to calm things down. But a weakening economy, once more, does make this more difficult. And the lack of automatic government bail-outs raises the cost of capital for more risky activities, which will contribute to China’s long-term economic slowdown. I expect China’s trend economic growth, probably only 3-5% pa over the last 5 years if properly measured, to slow further.