200% and counting

By S.R. | HONG KONG

Fears of a property crash, corporate defaults and austerity in the age of anti-corruption all came to naught. China’s growth sped up in the second quarter, climbing to 7.5% year-on-year, smack in line with the government’s official target.

Easier credit conditions provided fuel for the rebound. But they also led to a rise in Chinese debt levels. China’s stock of credit reached a dubious milestone in the second quarter: it is now equivalent to exactly 200% of GDP, having risen steeply over the past five years. Here is a chart showing China’s credit-to-GDP ratio since 2002:

(Note that the 200% figure is arrived at after stripping out equity financing, which the central bank includes in its calculation of ‘total social financing’ but ought not to count as credit.)

Does this mean that China faces a debt crisis? Far from it. The aggregate credit-to-GDP ratio covers government, corporate and household debt. Although 200% is at the high end for developing nations, it is below aggregate debt levels in more mature economies. Data from 2011 published by the McKinsey Global Institute (excluding borrowing by financial institutions) shows that the euro-area crisis countries had far higher debt-to-GDP ratios, from 260% for Greece to more than 400% for Ireland.

It is also important to remember that external borrowing is often the trigger for debt repayment trouble, and in that respect China still looks very strong. The vast majority of its debt is held domestically. External debt has risen sharply, to about $1 trillion, but that is still just a little over one tenth of GDP, and foreign exchange reserves are nearly four-fold higher, providing ample coverage. What’s more, much of the domestic debt comes in the form of loans by state-owned banks to state-owned companies. The risk of banks calling in the loans and so causing a wave of defaults is very low.

But does China face a debt headache? Most certainly. More worrying than the total debt level is the rapid rise. China’s credit-to-GDP ratio has risen by 58% since the start of 2009, when banks pumped out a torrent of loans to fund the government’s gargantuan stimulus programme. In recent years the government has tried several times to rein in debt, only to back down when it became clear that deleveraging would be painful.

Credit-to-GDP levels were stable in the second half of last year at about 190%, but a very bumpy start to this year – the country’s first bond default and stress in shadow banks – prompted the government to reverse its stance. A series of loosening measures, including a re-lending facility by the central bank that some analysts likened to quantitative easing, helped put growth back on track.

But the reopening of the lending taps means debt is an even bigger burden for the economy. With credit at 200% of GDP and average financing costs of roughly 7%, Chinese borrowers now need to generate cash-flow growth of 14% to cover their interest payments without eroding their profitability or being forced to borrow yet more. That is a tall order in an economy in which nominal growth is now running at 9%.

The upshot is that China’s credit-to-GDP level looks set to continue its steady drift upwards. Debt is a habit that, once formed, is hard to break.