Jake's View

How to counter the doomsters who say China has too much debt

‘There is no fixed percentage danger point for debt to GDP’

PUBLISHED : Wednesday, 07 December, 2016, 4:20pm
UPDATED : Wednesday, 07 December, 2016, 11:20pm

Consensus expects China’s debt levels to continue to rise sharply, possibly reaching about 300 per cent of gross domestic product by the end of 2018 and hitting 320 to 330 per cent by the end of the current five-year plan that spans 2015 to 2020.

“These are eye-wateringly high levels of debt for a developed market, let alone an emerging market ...”

SCMP, Dec. 6

Actually it is emerging markets that tend to run the higher levels of debt but let’s leave that aside. The question is whether 300 per cent of GDP would be too high a level of debt for China. I put it at about 215 per cent at present.

Take note first that this is a comparison of apples to oranges, for financial markets a comparison of stock to flow. It’s like saying that Siberia is in danger of flooding because Lake Baikal holds 300 per cent more water than its annual drainage.

The fact is that at some point in your life you may be entirely happy to run a personal debt to GDP ratio of not just 300 per cent but up to 1,000 per cent. It is when you buy a home and your mortgage (debt) may be up to 10 times your annual after tax household income (GDP).

There is no fixed percentage danger point for debt to GDP. The real question is whether the money is well invested

Yes, it is a big decision, perhaps the biggest commercial one you will ever make and wouldn’t you just slaver these days to find a debt to income ratio of only 300 per cent in buying a home. Why then is it so bad for average debt across a country to be 300 per cent of income?

In fact, it can be very a good idea some times. There are really only two ways of financing a purchase, equity and debt, and financiers assign a cost to equity as well as to debt.

They are not charged interest on equity but they do not assume it comes free. Even if they do not invest it on behalf of others who want a return, there are many things they can do with this money to return them more money.

They thus assign a notional cost of capital to equity to reflect the minimum percentage return they expect from it and if this, for instance, is 6 per cent when they can get debt at 3 per cent then debt rather than equity finance is the obvious responsible way to go.

You may say they ought to think long term as interest rates may rise and they could then find themselves with a much higher cost in debt than they would have had in equity.

This is true but in a world where interest rates everywhere have been driven to near zero for eight years by irresponsible monetary policies in the United States and Europe what surprise is it that people now expect ultra-low interest rates on a long term basis?

There is another reason for high debt ratios in China. Traditionally, since 1949 at least, it has been the state that takes all the equity. Homes are assigned and stock markets are only a recent and rather disappointing innovation.

Savers thus have little option aside from bank deposits and these consequently now amount to about 210 per cent of GDP, almost all of it advanced as debt. The equivalent ratio in the US is about 56 per cent. Americans have more investment options.

Cut to the chase. There is no fixed percentage danger point for debt to GDP. The real question is whether the money is well invested and, yes, I tend to the view that it has not been. Misallocation of capital is a hallmark of state planned economies.

But the danger does not primarily lie in there being too much debt.