China: Debating debt and investment Global Economic Outlook, Q4 2016

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New studies debate whether China’s debt level is excessive and dangerous, and whether the massive investment in infrastructure did actually create economic value. Meanwhile, new data from the Chinese government indicate that the economy appears to be stabilizing.

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The topic of Chinese debt continues to generate interest and controversy. A new study from the Bank for International Settlements (BIS), which is a clearing house for the world’s central banks, says that China’s debt level is excessive and dangerous. It looks at the “credit gap,” which is the percentage difference between total debt as a share of GDP and its long-term trend. Right now, according to the BIS, China’s credit gap is over 30 percent, three times higher than the level the BIS deems to be dangerous, and far higher than any other major emerging market. China’s gap has been steadily rising since 2011. The BIS says that the credit gap “has been found to be a useful early warning indicator of financial crises.” It also notes that China’s total debt, including both private and public sector debt, is now about 255 percent of GDP.1 This compares with 279 percent for developed economies on average and 394 percent for Japan—suggesting that China’s debt level is not excessive.2 Yet China is an emerging country, and emerging countries historically carry far less debt as a share of GDP than developed economies. In addition, China’s debt is disproportionately issued by the corporate sector rather than by the government, which is problematic because, unlike governments, corporations cannot raise taxes or print money. Thus their debt is riskier. Meanwhile, the BIS says that China’s high credit gap indicates that banks ought to have more capital.

A new study from the Bank for International Settlements says that China’s debt level is excessive and dangerous.

Meanwhile, Chinese bank lending continues to grow. It accelerated in August, doubling from the low level recorded in July. The volume of outstanding loans was up 13.0 percent from a year earlier. However, most of the increase was due to strong mortgage lending, indicating that businesses are not substantially tapping into formal credit markets. Rather, household borrowing accounted for 71.0 percent of new bank loans, most of that undertaken for property purchases. In addition, total social financing (TSF), a broader measure of credit creation that includes off-balance-sheet lending by banks as well as bond issuance, tripled in August from the previous month. Historically, property developers and state-owned enterprises have tapped into the TSF market.

The acceleration of credit creation partly reflects an easing of monetary policy by the central bank, including efforts to stimulate the property market. Lower interest rates and smaller down-payment requirements for homes have evidently fueled property investment. However, policy makers are likely concerned that businesses are hoarding cash rather than investing. This reflects the fact that China is plagued by excess industrial capacity, declining wholesale prices, and weakening profits. As such, it might not make sense for policy makers to ease monetary policy any further if it only serves to boost property investment but does nothing for business investment. Moreover, excessive property investment could ultimately lead to a sharp drop in property prices, thereby leading to difficulties in servicing debts. Thus policy makers find themselves caught between a desire to avoid a contraction of credit and a desire to avoid excessive credit creation.

The acceleration of credit creation partly reflects an easing of monetary policy by the central bank, including efforts to stimulate the property market.

The latest data suggest stabilization

Recently, there was a spate of new data from the Chinese government indicating that the Chinese economy is stabilizing, fueled in part by government stimulus and an easing of monetary policy. Here are some of the details:

  • Industrial production increased 6.3 percent in August versus a year earlier, the fastest rate of growth since March 2016. The manufacturing component of industrial production was up a healthy 6.8 percent. By ownership, output was up only 3.6 percent for government-owned enterprises, up 6.4 percent for shareholder enterprises, and up 6.7 percent for foreign-funded enterprises, including those funded from Hong Kong and Taiwan. This comes despite considerable weakness of exports.
  • Investment in fixed assets was up 8.1 percent in the first eight months of 2016 versus a year earlier. This included a 21.4 percent increase in investment spending by state-owned enterprises, which account for 61.4 percent of total investment. There were big increases in investment by state-owned enterprises, heavy industry, high-technology companies, and for the purpose of building infrastructure. Evidently, government efforts to stimulate the economy played a role in much of this. The big investment increase by state-owned enterprises is worrisome because such businesses are laden with excess capacity and declining profitability. This comes despite efforts to shutter superfluous factories.
  • Investment in real estate in China increased 5.4 percent in the first eight months of the year versus a year earlier. This included a 4.8 percent increase in residential property investment. However, the high volume of residential starts suggests that property investment will accelerate in the months ahead. Floor space of residential starts was up 11.7 percent. Plus, there was considerable turnover in the property market. Floor space of residential buildings sold was up 25.6 percent, and the value of residential buildings sold was up 40.1 percent. This is worrisome given the large excess capacity in this market. It reflects government efforts to stem the slowdown in such investment.
  • China’s retail sales increased 10.6 percent in August versus a year earlier, the fastest rate of growth since December of last year. This included a 13.1 percent increase in automotive sales. Real, or inflation-adjusted, retail sales were up 10.2 percent. The relative strength of retail spending is welcome given the need to transition economic growth away from dependence on investment and toward dependence on consumer spending.3

The efficiency of investment

One of the factors that allegedly contributed to China’s strong economic growth in the past few decades was a massive amount of investment in infrastructure. Indeed, the data reveal that this continues apace. Yet a new study by Oxford University researchers says that more than half of such investments have “destroyed, not generated” economic value. The researchers report that the cost of the investment in these cases exceeded the economic benefit, often resulting in unserviceable debts. The report states:

Far from being an engine of economic growth, the typical infrastructure investment fails to deliver a positive risk-adjusted return. Poorly managed infrastructure investments are a main explanation of surfacing economic and financial problems in China. We predict that, unless China shifts to a lower level of higher-quality infrastructure investments, the country is headed for an infrastructure-led national financial and economic crisis.

The report also poured cold water on the notion that infrastructure played a vital role in China’s rapid growth. It said, “It is a myth that China grew thanks largely to heavy infrastructure investment. It grew due to bold economic liberalization and institutional reforms, and this growth is now threatened by over-investment in low-grade infrastructure.” It warned against other emerging markets focusing too much on the quantity of infrastructure investment rather than market-opening reforms.4