Guest post: China’s debt time bomb – the fall out
Guest writer | Dec 02 2014 12:29 | 2 comments
By Gabriel Sterne and Alessandro Theiss, Oxford Economics
If there was a financial crisis in China, the government could take a big hit, transferring a huge chunk of bad debts onto its balance sheet. But this remedy would have a big impact on the domestic and global economy.
Overall debt (public, private and financial) has skyrocketed in recent years, rising from 176 per cent of GDP in 2007, to 258 per cent of GDP by mid-2014. The debt binge may be fuelling a time bomb in the property market.
Source: Oxford Economics
But so far, public debt has remained moderate by international standards. It is around 45 per cent of GDP if you include local and central government direct liabilities (see chart). The figure goes up to around 55 per cent of GDP if you factor in off-balance sheet liabilities, including via local government financing vehicles (as the International Monetary Fund has done).
Bailout costs
The size of bailout costs in the event of a financial crisis would depend upon three main issues regarding exposures of both banks and shadow banks: (1) How big are they? (2) How bad would loans get? (3) Which institutions will be allowed to fail? We take the issues in reverse order.
Issue 1: Who can be allowed to fail?
We assume the state bails out all banks and local government liabilities, given concerns over contagion.
Some shadow banking activities have been allowed to fail, in particular risky Trust products. But in our calibration, two thirds will be bailed out again due to financial contagion risks and implicit guarantees.
Issue 2: Bad debts shoot up, reaching over 20% of total loans in the case of banks.
Non-performing loans (NPLs) would be set to rise dramatically from current recorded levels of under 2 per cent of total loans. In a crisis scenario, they could reach over 20 per cent.
We are guided by several pieces of evidence.
First, following rapid credit expansion in the mid-1990s, China’s NPLs topped 30 per cent of the total in 1999. Some re-emergence in the relationship is to be expected, given the credit boom.
Second, equity prices of the four largest lenders have plummeted to just 70 per cent to 90 per cent of their book value. And these are widely perceived to be healthier than the smaller, regional banks.
Third, the international experience suggests China’s current combination of massive credit expansion and low NPLs is such an outlier that it cannot last. The chart below shows peak NPL levels in selected crises since 1980.
Source: Oxford Economics
The main damage will come from banks’ loans to corporates. Household lending is less risky, while much of the exposure to other financial institutions– while risky – is underpinned by the likely bailouts.
Asset deterioration in the risky shadow banking products could be more severe, reaching around 30 per cent of total exposures. Lending activities of trust products in particular are concentrated in risky areas such as real estate. But the fallout in our scenario is dampened by our assumption that all exposures to local government financing vehicles are backstopped by the state.
Issue 3: regarding size, bank lending to corporates dominates
At well over 100 per cent of GDP, the scale of bank loans to corporates is much higher than all other lending.
In spite of all the furore, the risky shadow banking activities of Trust and Wealth management products are much smaller, with exposures to non-government still only 35 per cent of GDP.
Putting all of the costs together, we estimate that a capital injection of 25 per cent of GDP would accrue to the government in our crisis scenario n (see table below).
Source: Oxford Economics
Such costs would not quite get China into the top 10 of bailout costs relative to GDP seen in the last 30 years; Indonesia (1997-01) tops the list with fiscal costs reaching 57 per cent of GDP.
Other debt dynamics
Even aside from financial sector bailout costs, over a three-year crisis horizon unfavourable debt dynamics could add a further 24 per cent to the debt-to-GDP ratio.
Source: Oxford Economics
Under a plausible China-crisis scenario, public debt increases by an average of 8 per cent a year during a three-year financial crisis as the fiscal deficit comes under pressure and growth slumps.
Conclusions
Summing up, we have calibrated a near-50 per cent of GDP increase in government debt following a three year financial crisis. This includes recapitalisation costs and other fiscal dynamics.
This would imply a debt-to-GDP ratio of around 95 per cent. Add another 10 per cent of GDP if you prefer the IMF augmented debt estimates.
That would leave China with a very high debt ratio compared to other EM. However, it would still be lower than the likes of Lebanon and Jamaica, not to mention numerous advanced economies.
Financing the substantial increase in government debt could in principle be achieved via issuance of more government bonds. For example, there would be a ready market from Chinese banks, particularly state-owned ones.
But with debt over 90 per cent of GDP, the scope for further government-sponsored credit expansion would become limited, further re-enforcing our view that Chinese long-term growth could disappoint.
Gabriel Sterne is Head of Global Macro Investor Services and Alessandro Theiss is Economist at Oxford Economics
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