China credit risks grow as debt produces less GDP, loans rolled over
Increase in borrowings and low level of bad loans are signals that debt is not being repaid
The mainland is requiring more and more debt to produce less and less growth. This raises the issue not just of where exactly all the money is going, but what happens once we all find out.
It is also causing concern that China might suffer a "Minsky moment", a classic debt bust when investors liquidate positions to satisfy debts taken out for speculation.
Even if we discount the possibility of a sudden bust, the low quality of investment in China implies substantial medium-term risks for its growth and for the growth and well-being of pretty much everyone else.
First the facts - while growth in the first quarter cooled to 7.7 per cent from 8.1 per cent a year ago, this was achieved in part courtesy of a 58 per cent bump in aggregate credit. On that basis, every dollar borrowed in China is now producing only 60 per cent of the growth it would have generated a year ago.
Since 2009, when China's leadership flooded the market with credit to counteract the slump, credit growth has exceeded nominal growth in gross domestic product in every quarter save one, a huge reversal from the earlier pattern. While aggregate credit created in April fell month on month, it was still up more than 70 per cent from the previous year.
"At the micro level, we notice that a non-negligible share of the corporate sector and local government financing vehicles are struggling to cover their financial expense. At the macro level, we estimate that China's debt servicing costs have significantly exceeded underlying economic growth," Societe Generale economist Wei Yao wrote in a note to clients. "As a result, the debt snowball is getting bigger and bigger, without contributing to real activity."
If China's debts were being repaid in instalments, like a mortgage, Yao estimates the country would have a debt service ratio of just under 30 per cent of GDP, with a third of that paid out in interest and the rest in repayments.
Even worse, it appears highly unlikely that debt is being repaid. Just consider credit growth, and then take a long hard look at the banking system's miniscule 1 per cent non-performing loan ratio.
The strong implication is that loans aren't being repaid but are being rolled into new loans, a classic credit bubble sign. That raises the prospect of a Minsky moment, a possibility that has been advanced by economist George Magnus of UBS, among others.
Under this theory, investors, unable to generate sufficient income from poor-quality investments, end up borrowing simply to keep the ball in the air. If loans are called, perhaps when an unexpected shock causes market prices to drop, investors end up liquidating not just the poor-quality assets against which they have borrowed but anything they can sell to raise money to meet margin calls.
The main, and so far successful, argument against Minsky having his 10 minutes of fame in China is the role of the state. Not only does China have reason to head off such an outcome, but with vast and effective control over the financial and banking systems, it has the means at its disposal to do so.
China, in planning tighter regulation over the shadow banking system, has given some indication that its willingness to support endless credit growth is not, well, endless. That's a far different thing from saying that it will force a crisis, or that it would not react strongly to one it did not force.
That still leaves us with two inescapable facts - there is a lot of debt, which ultimately needs repaying and restructuring, and the quality of the projects and enterprises into which the debt has been funnelled is not high.
All of this makes the most likely outcome a few years of disappointing growth as China muddles through its debts and works towards a more consumer-oriented economy, one less dependent on capital investment.
Recent comments by Premier Li Keqiang that China needs average annual economic growth of only 7 per cent to reach its goal of doubling per capita gross national product by 2020 indicate that, if anything, the risk is on the downside of the current medium-term consensus.
The implications for the world are, obviously, huge. China has been the great marginal buyer of natural resources and even if it doesn't suffer a bust, a protracted gentle slowing will be keenly felt.
Tom Holland is on holiday