Jake's View

We are missing the real problem with China’s mounting debt

High levels of debt are not necessarily a bad idea

PUBLISHED : Monday, 30 May, 2016, 3:48pm
UPDATED : Wednesday, 01 June, 2016, 3:09pm

China’s government debt ratio – including direct and contingent debt – was just 41.5 per cent of gross domestic product at the end of last year... Combined debt in government, corporate and household sectors has been estimated by analysts to be between 250 and 280 per cent.

SCMP, May 28

Here we have debt, a balance sheet figure contrasted to GDP, a form of cash flow figure, as if they are the same thing. This is a classic case of comparing apples and oranges.

Back to basics. A balance sheet is a two part statement. On the assets side it sets out the cost or estimated value of a company’s assets and on the liabilities side whether these are financed by debt or by shareholders funds. Total assets and total liabilities are always equal. Guess why they call it a balance sheet.

A cash flow statement sets out whence came all the money that flowed through a company’s hands over a given period and where it then went.

The basic measure of how much debt a company carries is debt to total capital employed – how much of the assets is financed by debt.

The real measure of danger is not how much debt is raised but rather how the money is spent

Comparing debt to annual cash flow helps you guess whether or not a company will have difficulty in repaying its debt but it is not definitive and much depends on the nature of the company’s business.

Now here comes another investment concept. Even a balance sheet can only give you an estimate of the value of a company’s assets. The real value depends on how much the assets generate in earnings or cash flow.

This will almost always be a multiple of those earnings or cash flows. Stocks trade at multiples of their earnings, bonds at multiples of their coupons and a bank deposit is still worth many time the amount of interest it pays you.

Take this back to the question of debt and GDP and let us assume that the value of a country’s assets are a multiple of that country’s annual GDP. For the sake of argument we shall make this multiple 10X. No-one really knows. People do not trade countries as they trade stocks. But 10X is likely to be in the ball park.

We are now comparing apples with apples and we now get central government debt at 4.15 per cent of total national capital employed. The equivalent figures for total debt across the economy are then 25 to 28 per cent. These are not high figures at all. In fact they are quite low by corporate standards.

Even this does not take into account that countries lend as well as borrow money and China is one of the world’s biggest creditor nations. I don’t know how much our ratios go down on a net debt basis but down they do go.

In any case, high levels of debt are not necessarily a bad idea. If interest rates are low they can be a very good idea. Debt is also generally considered the best way to finance costly infrastructure. Why then worry about debt in China?

Answer: Because the real measure of danger is not how much debt is raised but rather how the money is spent. It is this that determines whether the debt can ever be repaid or even serviced with scheduled interest payments.

The pessimist’s case is that Beijing has rashly encouraged the banking system it still tightly controls to lend much more money than is wise in order to keep economic growth from declining further in the near term.

There is certainly evidence to back up this view. In fact it appears to be a hotly debated topic within the leadership.

And it is not just recent. Sceptics have long said that local government borrowings have mostly been wasted, that big infrastructure projects like high speed rail can never pay even their operating costs and that too much money has been misdirected to speculation.

If this is true, and on balance I lean to the view that it is, then any amount of further debt may be too much and Beijing invites a financial crisis through misallocation of capital.

But whether too high or too low or just right at the Goldilocks level, let’s compare apples with apples and oranges with oranges.