Rescaling China’s Debt Mountain

MONTREAL – There is widespread agreement on two facts about the Chinese economy. First, the slowdown has ended and growth is picking up. Second, not all is well financially. But there is no agreement on what happens next.

The good news is that domestic demand continues to grow. Car sales were up nearly 10% in March over the same month in 2015. And retail spending grew at an annual clip of 10% in the first quarter.

The most dramatic increase, though, is in investment. Real estate investment is growing again, following its collapse in 2015. Industrial investment, especially by state-owned enterprises, has been rallying strongly.

At the root of this turnaround is enormous credit growth, as the authorities, concerned that the earlier slowdown was excessive, encourage China’s banks to lend. Credit growth, known in China as “total social financing,” grew at an annual rate of 13% in the fourth quarter of 2015 and again in the first quarter of this year – that is, double the rate of annual GDP growth. Since the financial crisis erupted in September 2008, China has had the fastest credit growth of any country in the world. Indeed, it is hard to point to another credit boom of this magnitude in recorded history.

The bad news is that credit booms rarely end well, as the economists Moritz Schularick and Alan Taylor have reminded us. China’s credit tsunami is financing investment in steel and property, sectors already burdened by massive excess capacity. The companies doing the borrowing, in other words, are precisely those least capable of repaying.

The International Monetary Fund, which tends to adopt a conservative posture on such matters (not least to avoid antagonizing powerful governments), estimates that 15% of Chinese loans to nonfinancial corporations are at risk. With nonfinancial corporations’ debt currently standing at 150% of GDP, the book value of the bad loans could be a quarter of national income.

It still may be possible to sell off vacant apartments for a fraction of their construction cost. It may be possible to sell off rolling mill machinery to other countries, or as scrap. But where the loans at risk are concentrated – in steel, mining, and real estate – suggests that losses will be substantial.

This is why the supposedly painless solution, debt-for-equity swaps, will not be painless. Yes, bad loans can be purchased by asset-management companies, which can package them up and sell them off to other investors. But if the asset managers pay full book value for those loans, they will incur losses, and the government will have to foot the bill. If they pay only market value, it will be the banks that incur losses, and the government will have to repair their balance sheets.

This leaves three unpalatable options. First, the authorities can issue bonds to raise the funding needed to recapitalize the banks. In doing so, they would effectively transform the corporate debt problem into a public debt problem. This would place the financial burden squarely on the shoulders of future taxpayers, which would not enhance consumer confidence.

It also would not enhance confidence in the public finances. Public debt in China is still relatively low; but, as any citizen of Ireland can tell you, it can balloon when banking crises strike.

Alternatively, the central bank could finance the repair by providing credit. But, while the authorities relied on this approach in 1999, the last time they were faced with a serious bad-loan problem, running the money printing press is not compatible with officials’ other stated goal: a stable exchange rate. We saw last August how investors can panic when the renminbi exchange rate moves unexpectedly. Currency depreciation may not only precipitate a destabilizing spiral of capital flight; it could also destabilize the banks, from which money leaving the country must first be withdrawn.

The final option is to imagine that the bad-loan problem will solve itself. The banks would be encouraged to “evergreen” their loans: to roll them over when repayment falls due. The fiction that the banks are well capitalized will be maintained. Borrowers that need to be liquidated or reorganized will instead stay alive, thanks to the drip-feed of bank finance. The result will look familiar to aficionados of Japan’s banking crisis: zombie banks lending to zombie firms, which apply artificial pressure on viable firms, stifling their growth.

Financing bank recapitalization through bond issuance is probably the least bad option. This doesn’t mean that it will be painless. Nor is there any assurance that Chinese policymakers will opt for it. But if they don’t, the consequences could be dire.