Could China’s Massive Public Debt Torpedo the Global Economy?
China might be the creditor to the world, but it is also riddled with debt. Between public and corporate debt, China is one of the most indebted large economies in the world. Even worse, its state-owned banks are sitting on mountains of bad debts and non-performing loans, particularly in the real-estate sector. And this is just on the surface. Underneath lies a staggering quantity of murky debt, off-balance-sheet lending, wealth management products, and local government funding vehicles. All told, China’s debt is considerably larger than it appears at first glance, and so high that some analysts feel it is at dangerous levels and could spill over, doing severe damage to the world economy. What does this say about the stability of the global economy and Western anxieties about China’s rise to a preeminent place in world affairs?
It seems that China’s meteoric economic rise may be grinding to a halt. The developing world could suffer most, particularly those countries dependent on selling natural resources to China or on Chinese aid. In developed countries, such as the United States, the main casualties will be people and companies heavily invested in Chinese companies and stocks. In the long term, there may be some positive outcomes. An economic collapse in China, or a severe economic downturn, may accelerate the general exodus of foreign companies from China, and a rebalancing of global supply chains. This would decrease the world’s dependence on China and could lead to a boom for nations such as Vietnam, India, or Indonesia, who are all too happy to host foreign factories that have left China. The benefits will take time, however. Negative effects will be felt immediately.
If the Chinese economy falters, it will affect all of its significant trading partners, which basically means the entire world. Countries around the globe will suffer from slower and more expensive exports as well as reduced demand for imports. Companies in China are suffering from supply chain disruption, higher input costs, pollution curbs, and logistical issues due to pandemic measures, such as fuel rationing, electricity rationing, and disruption at ports. Factory-gate prices, the price of products at the factory, have been steadily rising. All of these circumstances have driven factory inflation to its highest level in 13 years.
Construction has reduced and the economy is sluggish. Factory outputs, once the drivers of the Chinese economy, have slowed. Imports of steel are down. Coal imports were down in October compared to September. Sellers of energy and coal, such as Mongolia or Russia, and raw material and mineral exporters in Africa and other developing parts of the world could suffer from a reduction in new construction in China. Companies heavily invested in China will also suffer. Additionally, U.S. pension funds, individuals, and institutional investors will suffer as they are invested in the $2.1 trillion dollars of Chinese companies listed on American exchanges. Holders of China’s foreign currency debt would also be at risk to the tune of $2.4 trillion. Developing countries, dependent on the completion of infrastructure projects through China’s Belt and Road Initiative, could be left with unfinished building sites, highways, and power-generation plants that prove to be both expensive and useless. Currently, Belt and Road projects are valued at over $1 trillion across 139 countries around the globe. In short, everyone, from the most to the least developed nations, could be impacted by a collapse of the Chinese economy.
In June of 2021, China’s second largest real-estate developer, Evergrande, failed to pay a short-term debt and the Chinese government froze the company’s bank accounts. The story dominated headlines for months with concerns that if the company defaulted on its $305 billion in liabilities, the fallout could not only drive down the Chinese economy but also possibly impact the global economy.
In October another Chinese developer, Fantasia Holdings Group, missed its repayment of $206 million in five-year dollar bonds. Later the same month, China Properties Group’s subsidiary Cheergain Group defaulted on $226 million worth of debt payments. Almost at the same time, another developer, Modern Land China, missed its payment of principal or interest on a $250 million bond. The most recent addition to the default club is homebuilder Sinic Holdings, which also defaulted on $250 million. Yet another Chinese developer, Kaisa Group Holdings, is in danger of missing its debt payments. The company was valued at about $1 billion, but saw its share price drop by 15 percent when the possible default was announced.
These cases were highly publicized but they are a bit of a red herring, as the true levels of China’s debt go far beyond the real-estate sector. At the end of 2020, China’s foreign debt, including U.S. dollar debt, stood at roughly $2.4 trillion. Corporate debt is $27 trillion, while the country’s total public debt exceeds 300 percent of GDP. China’s public debt is already 60 percent higher than the average across other countries, and the debt-to-GDP ratio is growing at a rate of about 11 percent per year. As China’s GDP has grown by less than 11 percent annually for the past 11 years, its debt is outpacing its GDP growth.
Most commercial banks in China are state-owned, and as such often make decisions based on government edict rather than economic pragmatism. This includes loaning money to state-owned, state-controlled, or state-favored companies and industries in spite of the risk that the money may not be repaid. Consequently, bad loans at Chinese banks hit $540.79 billion in 2020. Chinese banks are also holding a class of non-performing loans in danger of default, which in China are called “special mention loans,” totaling $990.22 billion. But the real number of potentially distressed loans is even higher.
Pandemic rules last year permitted many businesses to delay repayment of principal and interest, but the loans remained on the books as “normal.” Many of these loans could slip into default once their payments are scheduled to restart, but for now there is no indication on the books which of them may or may not be in distress. Some non-performing loans may be “hidden” by moving them off the balance sheets of banks and on to the balance sheets of entities specifically created to absorb non-performing loans.
Distressed or potentially distressed loans may also be undercounted due to the way in which China classifies non-performing loans, which differs from that in the United States. Many of the “normal” loans in China would qualify as non-performing in the United States, where loans would be considered non-performing loans if they are non-accrual loans, as well as loans which are 90 days past due but still accruing interest. This is a much stricter definition of non-performing loans, as China has five classes of problem loans. On the balance sheets of Chinese banks, loans may be carried as “special mention” rather than non-performing loans, even though the risk of default is extremely high. In many cases, the loans are secured by inflated real-estate holdings, and loans are considered normal by banks even if the company that took the loan is in financial trouble.
To get non-performing loans off a bank’s balance sheets, they are often bundled and sold to investors. So the number of non-performing loans that would be on the balance sheet if not for these sales is much higher. For investors, the price of these bundles of non-performing loans is dependent on the statistical probability that the loans will be repaid. By obscuring the repayment risk, the bundle can be sold at a higher price. Researchers estimate that over 70 percent of non-performing-loan bundles were resold at inflated prices. Additionally, given the way in which the bundles are structured, the bank may still be the ultimate guarantor even though the loans are no longer on its balance sheet. Consequently, Chinese banks’ actual exposure to non-performing-loans could be much higher than reported.
A proxy measure for the health of bank loans would be to compare the amount of loans the banks made to the income they earned from those loans. Banks in China have seen diminishing income from loans, which suggests that non-performing loans are higher than reported figures. This fact is often obscured by Chinese banks posting high profits, but profits are somewhat subjective and bad loans moved off the balance sheet may not count in the revenue minus costs calculation. But the volume of interest income compared to the volume of loans made is a purely objective indicator, and one that suggests that Chinese banks are not doing as well as they appear to be.
From Bad to Murky
A related, overlapping source of debt is the so-called shadow banking industry, lending that occurs through non-traditional financial institutions. The shadow banking sector as a whole was estimated to have a total value of about $13 trillion dollars in 2020.
More murky debt can be found in the wealth management product market, totaling $1 trillion. Wealth management products are sold by banks as low-risk, high-yield investments, much of the proceeds of which are used to fund the property industry. Similar to what happened in the U.S. mortgage crisis, the government imposes strict rules on what quality of debt can be included in these products, but banks have found ways to bundle substandard debt and sell it at higher prices.
Local government debt is another cause for concern. As part of China’s development plans over the past decades, the central government has pressured local governments to increase economic growth through infrastructure spending, funded through local government financing vehicles. At the close of last year, China’s local government debt officially stood at $3.97 trillion. Once again, however, experts believe the real number is much higher. In addition to known debt there is “hidden debt,” which comes from local governments standing as guarantors for other entities that borrowed money. Off-balance-sheet borrowing is done through so-called local government funding vehicles, which are formed for the sole purpose of borrowing money that is then invested in local infrastructure development. Consequently, the debt is not carried on the books of the local government, but rather on the books of the local government financing vehicles, although the local government is actually liable for the loans. The debt value of these local government financing vehicles has nearly tripled over the past eight years. According to a Goldman Sachs estimate, “hidden debt” could be as high as $8.2 trillion, just about half of China’s GDP.
Local governments have been issuing bonds in record numbers. They had a quota of $3.75 trillion in 2021 but the central government, in an attempt to reduce debt, has cut the quota to $3.65 trillion. However, even a reduction in bond quotas is still piling debt on top of debt. 60 percent of the proceeds from these bonds have not been used for infrastructure investment, but rather to repay maturing debt.
About a third of local government income is generated by selling land to property developers. This puts local governments, the developers themselves, and the banks in a position of bias toward making more loans rather than fewer. Banks have been able to grow their on-paper profits by making questionable real-estate loans while rolling bad debts over to the next quarter. Comprehensively measured, the property industry may account for roughly 29 percent of China’s GDP and about 30 percent of all loans at financial institutions.
Overseas bond defaults by Chinese companies are increasing, reaching $8.7 billion in 2021, 34 percent of which were bonds from real estate companies. On the domestic front, many Chinese developers are facing liquidity issues, increasing the risk of default, including Evergrande Group, whose $305 billion debt is equal to about two percent of China’s GDP, Fantasia Properties, in danger of defaulting on $4 billion, , and Tahoe, which owes about $6.7 billion. Real-estate sector bond defaults increased 159 percent year-on-year, and there may be more to come.
A Paper Tiger?
In 2020, in spite of a coronavirus economy, China was reported as the world’s largest recipient of foreign direct investment at $163 billion, although much of this investment came via Hong Kong so this figure may be a bit misleading. The point still stands, however, that China is still one of the world’s preferred destinations for foreign direct investment. And while there has been a general trend of foreign companies leaving China, there are still 175,400 foreign firms registered in the country, trying to capitalize on its 1.4 billion potential customers. In light of the massive debt and bad loans being carried by local banks, it appears that doing business with or in China is becoming riskier. As the economy slows further, and as banks curb their lending, infrastructure investment and new construction projects will grind to a halt. This will drive up unemployment, decreasing demand for everything from building materials to factory inputs to consumer goods and services.
Most likely, the Chinese economy will no longer grow at the incredible pace that it has for the past three decades. Apart from destructive control decisions taken by Xi Jinping and the Chinese Communist Party, reduced future growth prospects are the result of the Chinese economy maturing while the population is ageing and the workforce is shrinking. Much of the growth since 2008 has been fueled with debt, a potential pitfall that was tolerated because job creation and increasing living standards were a priority. Now, however, job creation may be less of a driver, making the Chinese Communist Party more willing to curb debt and bring under control those aspects of the economy that were allowed to run wild in the name of greater growth.
It is extremely unlikely that the Chinese Communist Party will be able to solve all of these problems or completely turn the economy around. The Chinese economy is too big and too complex to be able to remedy the deeply ingrained issues that have become endemic. To bring the Chinese economy in line with those of Western nations, particularly the United States, the Chinese Communist Party would have to undertake deep, systemic changes that it is unwilling to consider, such as decentralization of control, granting rural land rights, and exposing the economy to risky market forces.
The current economic problems, while tremendous, do not signal the end of China as a global power. The country is more than likely to remain the world’s second largest economy and the primary rival of the United States. The Chinese role will change, however, in that they will be less of a driver of global growth and will no longer be speeding, inevitably, toward the position of paramount world power.
Antonio Graceffo, Ph.D., China-MBA, spent seven years in China and is the author of the books Beyond the Belt and Road: China’s Global Economic Expansion and A Short Course on the Chinese Economy. His writing has appeared in The South China Morning Post, Penthouse, The Diplomat, and Black Belt Magazine. He currently resides in Ulaanbaatar, Mongolia where he teaches economics at the LETU American University.