What China's balance sheet tells us about the state of the economy

Andrew Sheng says just-released balance sheet data underlines frailties and direction for reform

PUBLISHED : Friday, 18 July, 2014, 2:32pm
UPDATED : Wednesday, 28 September, 2016, 8:44am

The Chinese Academy of Social Sciences has just published a book on China's national balance sheet in 2013. Led by Dr Li Yang, the academy's vice-president and director of its Institute of Finance and Banking, a team of academy researchers has built on an earlier study by Dr Ma Jun, currently chief economist at the People's Bank of China.

For the first time, the study reveals a rich and fascinating series of data that one can use for comparison with other countries. In the past, most economic analyses have focused on flows - the amount of annual trade, investments or gross domestic product.

Balance sheet data, by contrast, reveals stocks outstanding at a point of time. They are much more difficult to compile, because of valuation and measurement problems.

It is only in recent years that economists have begun to realise that a study of balance sheets is critical to detecting an economy's state of robustness or its fragilities, particularly at the sectoral level. Dr Richard Koo, chief economist at Nomura Research Institute, has famously said that Japanese deflation and the most recent global financial crisis were balance sheet crises, an analysis now accepted by most economists.

We all worry about asset bubbles, but we cannot assess whether these bubbles are fatal for the economy unless we have a handle on their scale and the way they are financed.

The United States, for example, has probably the best series of balance sheet data through its quarterly flow of funds analysis published by the Federal Reserve Board.

The latest available balance sheet data, for the first quarter of 2014, reveals that the US economy is on the path of recovery, with the household sector continuing to reduce its debt. Its net worth has increased considerably since the crisis in 2007, thanks to the recovery in the stock and bond markets. This could unravel if interest rates rise.

Recovery in the household sector is crucial for the US economy, because it accounted for 90 per cent of US net assets, whereas the federal government had a net liability. This is in sharp contrast to the Chinese situation, where the household sector accounted for just under half of national net assets, while the central and local governments accounted for a quarter and the enterprise sector the remaining quarter.

The first distinguishing feature of the Chinese national balance sheet is that the state still dominates ownership, even though progress in private ownership has been considerable since reforms began in 1979.

The second distinctive feature is that China is a net lender to the world. At the end of 2013, China had net claims on the rest of the world equivalent to 21 per cent of GDP. In contrast, the US owed the rest of the world 32 per cent of its GDP.

This being the case, China's shadow banking issues are not a global threat, since foreigners do not have much exposure. It is largely an internal debt issue.

The third feature is that the bulk of Chinese net worth lies in real assets, particularly housing, fixed investments and land, whereas US net wealth is mostly in financial wealth. Chinese gross real assets were 611 per cent of GDP in 2011, compared with the US equivalent at 406 per cent of GDP.

The main reason for this is the high level of fixed-asset investment by the Chinese. This is explained by the exceptionally high level of investment by Chinese enterprises and local governments in recent years.

A fourth feature is the high level of financialisation of the US economy compared with China, with the former having financial assets equivalent to 1,053 per cent of GDP, double that of Chinese financial assets (546 per cent of GDP).

US financial assets are mostly in debt instruments and equity, whereas Chinese financial assets are mostly in bank deposits and bonds, with nearly half of GDP holdings in foreign exchange reserves. US equities were 148 per cent of GDP, significantly higher than the 23 per cent equivalent in China. The weakness of China's equity markets meant Chinese enterprises were more debt-dependent and highly leveraged.

Indeed, the recent rapid growth of Chinese debt-to-GDP ratio can be largely explained by the accumulation of debt by Chinese enterprises and local government financing platforms.

The good news is that the central government balance sheet is still healthy, with net assets of 87 trillion yuan (HK$109 trillion), of which 70 trillion yuan is equity in listed state-owned enterprises. Much of this will be needed to help restructure local government finances and state-owned enterprise debt.

The national balance sheet numbers suggest that China's high investment stock, funded largely by debt, will require deeper capital markets to finance in order to make the system more resilient to shocks. But having real estate numbers so high also means that the system is vulnerable to deflation in real estate prices.

This makes the current reforms to get the economy and balance sheet into balance more urgent than ever.

Andrew Sheng is a distinguished fellow of the Fung Global Institute