China’s Two Choices: Crisis or Stagnation

Why the country cannot deleverage

A worker cleaning a diesel engine part in Qingdao, China, Aug. 29, 2017. China's economy has been strong recently but Daniel Lacalle argues there will be a price to pay. STR/AFP/Getty Images

China’s third-quarter GDP growth of 6.8 percent was suspiciously in line with the government mandate and most analyst estimates. But when growth is no concern, debt saturation and diminishing returns of the central-planning model are.

Chinese total debt has surpassed 300 percent in 2017. The money supply keeps increasing at close to double-digit rates, or 9.2 percent, compared to last year in August.

China has added more debt in the first nine months of 2017 than the United States, Japan, and the European Union combined.

While central and local government debt remains stable at around 60 percent of GDP, private sector debt increase is a major concern. The vast majority of the largest quoted companies (60 percent of the Hong Kong stock index Hang Seng, where many Chinese companies trade) have published results with returns significantly below their cost of capital. According to the Financial Times, zombie firms have soared as growth fails to catch up as debt and interest increase.

Additionally, in a situation that mirrors the reckless international buying spree of European conglomerates in the early 2000s, the results of foreign capital investments at very high prices have generated a backlash for Chinese multinationals. The central government’s legion of zombie firms (those unable to cover interest expense with operating profits) includes 2,041 large companies with assets worth some $450 billion.

China government debt Institute of International Finance

Debt itself is not a problem, if it’s used for productive investment. But a glance at the Hang Seng Index shows an abysmal return on investment assets of 1.33.

Even if we look at what has been optimistically called “the new economy,” Chinese companies have a similar combination of weak fundamentals and poor capital allocation. The “new economy,” driven by high productivity sectors, is heavily dependent on strong capital markets in order to finance growth via bonds and equities. A surprisingly low nonperforming loan ratio of 1.67 percent is probably too low, and Fitch, for example, estimates that the real figure is 10 times greater than the official one. A weaker stock market and the contagion effect of rising nonperforming loans hits the weak and obsolete dinosaurs of the old economy as well as the nascent, thriving sectors alike. We saw it in Taiwan, Japan, and the European Union.

No Deleveraging

Can you imagine what would happen to these extremely low returns if GDP growth was reduced to a more sustainable 4 percent? A complete collapse of the economy. This is one of the reasons why—despite public messages suggesting the opposite—that the government cannot and will not make debt reduction a priority.

“China requires 6.5 units of capital to create one unit of gross domestic product growth, double the ratio of a decade ago,” wrote the Financial Times, citing a report by investment bank UBS.

After years of expanding mortgage debt, even fiscally responsible Chinese households have too much debt. Household debt to GDP has multiplied by four in the past 10 years. China, once supported by strong household savings, is on a debt binge. By 2020, households will have the same ratio of mortgage payments to disposable incomes than the peak level in the United States before the financial crisis.

This is the second reason why China cannot put deleveraging, or debt-reduction, as a priority. The Chinese economy is unable to tackle a social crisis if house prices moderate, let alone fall once the housing bubble bursts. China does not have a welfare system to provide a cushion if a domino of bankruptcies happens in the household sector.

These factors make China’s mirage of deleveraging impossible. At best, we will see a monster increase in public debt when the private sector can’t put on more debt. However, while public debt is low on the surface adding liabilities of state-owned banks would easily double the official debt to GDP figure.

China has a few options, all of them bad. Most of the debt is in local currency with local banks, so the government could devalue the currency drastically to wipe out the debt. But doing that would hurt economic growth and send inflation to socially unacceptable levels.

And that would be a benign scenario. China can endure the end of its vicious circle of poor capital allocation, high debt, and rising imbalances through stagnation, thus avoiding a social collapse by massively increasing public debt. But that is all it can do. A giant financial crisis would reboot the system and create an environment for sustainable growth, but at the same time pose significant social challenges. To avoid this, China will have to accept high-debt-zombified stagnation the way that Europe, Brazil, and Japan ended their debt cycles. There is no magic solution that will sort out these imbalances while at the same time continuing to deliver world-beating GDP growth figures.

Daniel Lacalle is chief economist at hedge fund Tressis and author of “Escape From the Central Bank Trap” (published by BEP).