MP Econ Issue 19: China Economy and Debt
By Damien Ma and Houze Song
Like many, we have been grappling with what to make of the Chinese economy’s prospects. It is evident that serious risks have built up, the manifestation of which is already apparent in the property sector. The key question is whether this is another cyclical speed bump—a tempest in a teapot—or the making of a protracted crisis.
After much deliberation, we believe the answer veers toward the latter. China is likely heading into a messy and protracted debt debacle that will be at least equal in magnitude to the state-owned enterprises (SOEs) debt drama in the late 1990s. Except the outcome this time will likely be a prolonged economic malaise, for two main reasons.
One, the macro conditions today are not nearly as favorable to China as they were 25 years ago. At a minimum, China will not be able to grow out of this problem like it did last time, helped in part by its entry into the World Trade Organization. Two, the main variable that determines the outcomes—the Chinese state’s response—is more concerning than it has ever been in recent memory.
These two factors are mutually reinforcing, because constraining China’s response is the current leadership’s strong pro-austerity stance. That stance is necessary from Beijing’s point of view, as it appears committed to de-risking the economy over the next three years and preparing to take the pain that comes with it. The hope seems to be that after de-risking, the Chinese economy will normalize to a sustainable growth of perhaps 4%-5%.
While any significant adjustment period will be painful, such de-risking will not fundamentally solve the leverage problem because this is a feature, not a bug, of China’s political economy. The current situation is simply a different manifestation of the same underlying ailment that also afflicted the late 1990s: the state sector’s soft budget constraint.
Back then, the crisis originated in SOEs; this time it will hit local governments. What the two episodes share is state actors that actively participate in the economy without being subject to true market discipline to shape their behaviors.
So long as this remains the underlying structural reality, China will have recurring debt cycles, and taming them will ultimately be a Sisyphean task. The best that Beijing can hope for is to manage through these cycles with the proper balance between growth and deleveraging.
Yet that balance seems absent in Beijing’s current approach. Its pro-austerity stance combined with the intent to vigorously pursue de-risking in a low-growth environment is not an optimal recipe. Such an approach will ironically increase, rather than mitigate, risks to the economy.
Instead, stimulating growth dramatically can inflate away debt or at least keep the debt-to-GDP ratio fairly stable. Would it be ideal if China shifted from its debt-financed growth model? Of course. But this is probably the least bad option given the reality of China’s political economy.
In fact, the accumulation of debt in an economy can be sustained for much longer than one imagines—just look at Japan and the United States—especially if it is mainly domestic debt. In other words, debt-financed growth is not necessarily “bad” in and of itself, so long as sufficient growth will allow for servicing that debt.
While it remains possible that Beijing could steer toward a growth agenda that addresses deflationary risks, there are few signals that it is earnestly doing so. Until we see more concrete evidence of an enduring shift, Beijing’s current path will unintentionally but likely lead to a local debt crisis that will damage the regional banking sector. Indeed, Beijing may envision the deleveraging process as a “controlled demolition,” but China’s economy and financial system are much more complex today, making the risks associated with this process much higher.
If our scenario materializes, the first-order effect will likely depress China’s growth prospects for the rest of this decade. Because this will mainly be a domestic debt debacle, the net impact on the global economy should be more modest, primarily hurting commodity exporters and certain Asian economies that have significant exposure to the Chinese economy.
Here we articulate a condensed version of our baseline view and will follow up with a more detailed assessment of China’s economic predicament.
The Three-Year Debt Debacle
In arriving at our view, we focused on addressing two core questions:
1. What is the nature and scope of this coming debacle?
2. What will be the Chinese state’s response?
1. The Nature and Scope of the Crisis
At a fundamental level, most if not all economic crises are essentially debt crises in various guises. China’s is no exception.
We believe the property sector crisis, which has largely peaked, is just a preview of the main event, which will see around 40% of local government financing vehicles (LGFVs) default on their debt. Defaults of this magnitude will affect regional banks that are most exposed to LGFV lending. We estimate total loss for LGFV creditors (including financial institutions such as banks and LGFV supplier/contractors) to be in the neighborhood of $5 trillion, or ~30% of China’s GDP.
This will likely be a slow-burn crisis with volatile peaks and troughs, playing out in two phases over roughly three years:
· Phase 1 (mid-2023 to mid-2024): the main feature of this phase will be property developer defaults.
· Phase 2 (mid-2024 through 2025): the main feature of this phase will be LGFV defaults and regional bank insolvencies.
The peak of Phase 1 has likely passed, and we would expect the majority of private developers to default and restructure their debt in coming quarters. In the meantime, land sales will likely continue to fall by more than 10% through 2024.
Declining land sales means dwindling fiscal coffers for local governments, which will force their hand in allowing LGFVs to default around mid-2024 or earlier. Of the estimated total $12 trillion in LGFV debt, at least 40% will not be paid back. Those defaults will primarily come from two categories of LGFVs we call “hybrids” and “garden variety”—which won’t receive bailouts—while “safe” LGFVs will likely get bailouts (see Figure 1).
Consequently, regional bank insolvencies will start to emerge either in synchronicity with the LGFV defaults or shortly thereafter, because regional banks’ lending to LGFVs account for nearly one-third of their total assets. We expect at least 30% of regional banks will be either acquired by bigger banks or go bankrupt (refer to our “Debt Hangover” index to see different regions’ exposure to default risk).
Figure 1. Debt Shares of Different LGFV Categories
2. The Chinese State’s Response:
Beijing’s response will likely be strong on saving major banks but weak on saving local governments. The central government will protect major banks by recapitalizing them while extending emergency lending through the People’s Bank of China to those safe LGFVs, which have borrowed heavily from major banks. Rescuing those LGFVs will moderate the impact on banks, with losses amounting to perhaps no more than 20% of their lending.
It is important to note here that Beijing must be selective in what it chooses to save because the scale of LGFVs is such that it is “too big to save all.” For instance, Beijing’s recent orchestration of more than $1 trillion for local government debt refinancing is likely aimed at this group of safe LGFVs. But such action should not be interpreted as central government willingness to bail out all troubled LGFV assets. Instead, this is likely a signal that once the safe LGFVs are protected, Beijing will greenlight defaults of the hybrid and garden variety LGFVs.
Dealing with the thousands of troubled LGFVs will be largely left to local governments, many of which will be incapable of handling the problem and thus will allow defaults. The central government isn’t likely to intervene much in this process. The most it will do is directly purchase local government bonds to put a floor on their finances to ensure that essential operations and spending can be maintained.
As with any debt crisis, the costs will have to be somehow socialized. The fact that the central government is only willing to shoulder a small portion of the cost, that means the private sector and households will ultimately bear the brunt of the cost.
According to our estimate, the private sector has ~$2 trillion exposure (mostly in the form of account receivables) to risky LGFVs. That could mean ~$1.6 trillion loss for the private sector, assuming a haircut of 80% on LGFV debt repayment.
Chinese households, on the other hand, will see both direct and indirect impacts. For wealthier households, they will likely suffer financial loss from having invested in LGFV debt products, such as trust lending. For average households, they will likely experience indirect costs such as cuts to spending on entitlements and public services—mainly funded by local governments—and higher taxes to raise revenue.
The impact on the private sector and households, the main drivers of growth, means that the Chinese economy will remain in the doldrums for quite some time. At a macro level, a Chinese economy that will grow significantly below its potential for many years means that the gap between the US and Chinese economies is unlikely to narrow much for the remainder of this decade. We will flesh out global ramifications in the follow-up assessment, as the impacts will vary for different countries/regions.
Damien Ma is the Managing Director of MacroPolo and Houze Song is a Fellow at MacroPolo.
The views herein are those of the authors. This product is exclusively analytical in nature and should not be considered investment advice.