Warnings about rising debt have not gone down well with China's leaders. But without some drastic action a similar crash to the west's 2008 will become increasingly likelyby / June 1, 2017 / Leave a comment
Last week, Moody’s Investor Services, one of the three main credit rating agencies, downgraded China’s sovereign credit one notch from Aa3 to A1. This affects the terms on which the government and its sub-national institutions can borrow money.
My own reaction to this news was “who cares?” China has precious little foreign debt, and what it does is denominated in its own currency.
Judging by Beijing’s reaction, though, I couldn’t have been more wrong. You’d have thought Moody’s had insulted President Xi Jinping himself. So what does the Moody’s announcement signify, and why does this esoteric credit news matter?
The Chinese Finance Ministry and the two main state media outlets, People’s Daily and Xinhua News, all laid into Moody’s because it had warned that China was likely to experience steadily escalating levels of debt, especially as economic growth slowed down. It was accused of presenting a misleading picture of China’s economy; overestimating the difficulty of boosting economic growth, and underestimating China’s capability in pushing ahead with supply side reforms and stronger demand (though it isn’t clear how you can do both); lacking knowledge of China’s laws and regulations and so concluding incorrectly that higher borrowing by local governments and state enterprises would lead to higher government debt; and losing credibility (along with other western credit rating agencies) because of its ingrained, flawed methodology.
Of the three complaints specific to China, none stands up to critical examination, and so China’s response was really a fit of pique. Moody’s had ruffled its feathers at a very sensitive time for its leadership and policy-makers. It is a bad time to tell the world negative things about China’s economy when the President is preparing for the important 19th Communist Party Congress later this year, at which he has an ambitious personal and constitutional agenda. It’s important everything goes smoothly.
But there is a narrative here worth summarising, because it illustrates the concerns that Moody’s and others have, and why China’s sensitivity is significant.
The Chinese government itself isn’t a major debtor—its liabilities account for only about 15 per cent of GDP. But it is unquestionably on the hook for all the debt owed by local and provincial governments, state-owned enterprises and other state entities that has been rising since 2008. By the end of 2017, China’s nonfinancial sector debt may well have reached or breached 300 per cent of GDP, compared with 260 per cent at the end of 2016. In less than a decade, China’s debt as a share of GDP has roughly doubled. What Moody’s drew attention to was the fact that China’s debt burden will only get worse if the credit expansion continues as it is now, especially if growth slows. Debt service capacity and financial stress would both rise, putting more pressure on the bad assets in the banking system. None of this, though, is new. China-watchers have seen this coming for some time.
And not only China-watchers, because China’s leadership is both aware and concerned. In May 2016, an anonymous but authoritative source, very possibly a close adviser of Xi Jinping, gave an interview to People’s Daily warning precisely of the dangers to the economy and financial stability of allowing debt to grow. Yet, nothing really happened. With credit growth of over 20 per cent per annum, China still haemhorraged both capital and foreign currency reserves, and the Renminbi continued to weaken.
Late in 2016, China acted to stem the capital flowing out of the country by strengthening existing and introducing new controls over capital movements. Then, in February this year, the new head of the China Banking Regulatory Commission, Guo Shuqing, seriously cracked down on financial excesses in the shadow banking system. This has had significant repercussions on the financial sector, including banks and insurance companies, pushed up financing costs, and made lots of people rather nervous. But if it starts to affect the economy, the authorities will very probably back off.
So Moody’s was right to focus on China’s debt, because it will need to be addressed sooner or later. At the same time, both Moody’s view and the government’s response divert attention from the deeper and more serious issue. Put simply, it is not the debt, per se, that’s the problem, but how it is funded. In a state-owned financial system, there are many ways that debt (which counts as assets for banks) can be hidden and problems deferred. But you can’t do that with the liabilities, that is the deposits which fund the loans. In China, banks and nonbank financial intermediaries are starting to rely more and more on short-term and volatile deposits, which could dry up at some point in the next couple of years unless the government chooses to put the credit genie back in the bottle. This is the sort of behaviour which caught us out in 2007-08, and will catch China out before too long. At root, it’s the funding not the debt that is China’s Achilles’ heel.