How manageable is China's red ink?

By R.A. | WASHINGTON

DOES China have a debt problem? China sceptics are increasingly pointing to stories about growing debt problems within China as a sign of looming trouble. China's high-speed rail construction effort, for instance, has accumulated a pile of debt too large, in all likelihood, to be manageable through rail revenues alone. And a new auditor's report indicates that local government debts may add up to nearly 30% of GDP.The Financial Timesreports:

“If you take a very broad view of the Chinese government's contingent liabilities rather than explicit debt on the books then the number comes to well over 150 per cent of China's GDP in 2010,” according to Victor Shih, a political economist at Northwestern University in the US. The US has a debt-to-GDP ratio of 93 per cent, while Japan's ratio is over 225 per cent.

And the New York Times adds:

Some analysts say an economic slowdown could expose huge hidden liabilities in the banking system. Many of the problems are tied to a $586 billion stimulus package Beijing announced in late 2008 and a huge wave of state-backed lending in 2009 and 2010. Those money infusions were aimed at buffering China from the global financial crisis...

Many analysts have grown cautious about China's economy. Some have reduced growth estimates and downgraded their ratings of Chinese banks over concerns about a coming wave of nonperforming loans associated with local government debt.

Last week, Charlene Chu, an analyst at Fitch, the credit ratings agency, said China's growth had recently become too reliant on loose credit and that “easy money” was helping fuel inflation and a property bubble, according to a presentation she delivered at a global banking conference in Hong Kong.

So, is there a problem here? I'd say yes and no. There is not a China debt problem in the way that there's a Greek debt problem. Tot up all the obligations, and they still don't amount to the sort of burden that's likely to trigger crisis, or even much of a near-term slowdown.

The chart at right indicates one reason why current debt levels aren't too frightening; they're not much higher than they have been across a period in which the Chinese economy grew extremely rapidly. Yes, local government borrowing soared behind efforts to keep the economy humming through the global crisis. But that rise has been offset by falling national and bank-restructuring bills.

China's debt load is also less problematic than rich-world burdens because its trend growth rate is so high. A debt-to-GDP ratio of 80% is a serious problem if near-term GDP growth is expected to be below 3% (as in America) or close to 1% (as in Japan). It's much less of one if near-term growth is forecast to top 9%, as China's is. Even if China's growth rate slowed to between 5% and 7%, its debt burden would rapidly erode so long as new borrowing were kept in check.

China also needn't fear foreign creditors. It's a challenge for any foreigner to obtain Chinese debt, and China's domestic financial system is heavily repressed by the government. That sounds bad, and in many ways it is, but it does make for easy debt reduction, particularly when inflation is high. The combination of a repressed financial system and high inflation allows China to "borrow" from domestic savers at a negative real interest rate. That's a good deal if you can get it.

And then, of course, China has those $3 trillion in reserves. So any way you slice it, debt payments are unlikely to place much stress on the Chinese economy.

But that's not to say that debts aren't a problem. I think a near-term economic crisis within China is unlikely. But I also think that many of the economic policy choices that make China's debt less of a near-term threat are likely to seriously complicate growth 5 or 10 years down the road. The essential lack of independence of big banks, the strict management of the financial system, and the distorting effects of these choices on real activity are increasing the odds that when China does face the inevitable slowdown in growth rates it will have a hard time moving toward other growth engines.

China's economy has a lot of easy growth ahead of it yet. There are still 600m Chinese living in rural areas, and industrialisation is far less developed well inland than it is along the coast. But ultimately, the economy will need to shift to a nimbler, more entrepreneurial, and more decentralised pattern of growth. It's not clear that China's government can accept the smaller role in economic affairs that kind of growth implies.

Do be sure to check out this week's China Special report, by the way. It's an excellent overview of the difficulties that lie ahead for China's leaders.