In the past 200 years, there have been more than 250 cases of sovereign-debt default, and 68 cases of domestic-debt default. None of these was an isolated incident. Indeed, such defaults have always triggered financial crises.
Since China's era of reform and opening up began, the country has experienced three instances of large-scale public-finance problems. In the late 1970s, it faced a debilitating fiscal deficit. In the 1990s, its corporate sector was plagued by "triangular debts" (when a manufacturer that has not been paid for its product is unable to pay its suppliers, which in turn struggle to pay their suppliers). Later that decade, financial institutions were burdened by bad debts generated by state-owned enterprises.
Now China is experiencing a fourth instance of elevated debt risk, this time characterised by high levels of accumulated local-government and corporate debt. China's national balance sheet, which boasts positive net assets, has garnered significant attention in recent years. But, to assess China's financial risk accurately, policymakers and economists must consider the risks that lie in the country's asset structure - and the liabilities that are not included on its balance sheet.
The current problems are rooted in the government's response to the 2008 global financial crisis. The first round of fiscal stimulus, supported by credit easing, led local governments and the financial sector to increase their leverage ratios. As a result, by 2010, China's overall leverage ratio had risen by 30 per cent.
By the end of 2010, local-government debt totalled 10.7 trillion yuan (HK$13 trillion), with only 54 of more than 2,500 county governments debt-free.
China's Treasury-bond debt stood at 7.2 trillion yuan at the end of 2011, and its ratio of foreign debt to foreign-exchange reserves reached 21.8 per cent, well below the widely recognised danger threshold of 100 per cent. Likewise, while China's debt-to-GDP ratio is rising, it remains within the "safe" boundary of 60 per cent.
Judging from its balance sheet, then, the Chinese government seems to be in a solid position to manage its liabilities. Indeed, according to the Chinese Academy of Social Sciences, China's sovereign net assets increased every year from 2000 to 2010, reaching 69.6 trillion yuan - enough to cover the government's obligations.
But positive net assets are not sufficient to eliminate financial risk, which also depends on asset structure (the liquidity of assets and the alignment of maturities of assets and liabilities). If a large proportion of a country's assets cannot be liquidated easily, or would be greatly depreciated by a large-scale sell-off, the fact that assets exceed liabilities would not rule out a debt default.
In China, this proportion of fixed, illiquid assets exceeds 90 per cent. Resource assets account for roughly half of total government assets, with operating assets amounting to 39 per cent and administrative assets comprising 6 per cent.
The latter two are difficult to liquidate. And, the traditional practice of auctioning and leasing land to keep the fiscal deficit under control is unsustainable. While fiscal revenues are on the rise, they account for only about 6 per cent of China's total assets.
China faces additional debt risks from contingent liabilities and inter-departmental risk conversion, especially in the form of implicit guarantees on debts incurred by local governments and state-owned enterprises.
In recent months, there has been a surge in local government investment vehicle bond issuance, aimed at supporting local governments' efforts to stabilise growth through investment projects. But the implicit guarantees on these bonds - as well as on existing bank loans - amount to hidden liabilities for the central government.
Local governments have also accumulated massive amounts of non-explicit debt through arrears, credits and guarantees. Once this debt's cumulative risk exceeds a local government's financial capacity, the central government is forced to assume responsibility for servicing it.
At the same time, China's corporate sector relies excessively on debt financing, rather than equity. China's non-financial corporate debt accounts for roughly 62 per cent of total debt - higher than in other countries. According to GK Dragonomics, its total corporate debt reached 122 per cent of gross domestic product last year.
Many of these heavily indebted enterprises are state-owned, and have borrowed from state-controlled banks. The implicit guarantees on this debt, too, suggest that the government's liabilities are much higher than its balance sheet indicates.
China is not too big to fail. In a fragile economic environment, policymakers cannot afford to allow the size of China's balance sheet to distract them from the underlying structural risks and contingent liabilities that threaten its financial stability.
Zhang Monan is a fellow of the China Information Centre, a fellow of the China Foundation for International Studies, and a researcher at the China Macroeconomic Research Platform. Copyright: Project Syndicate