Macroscope | Deleveraging is the wrong way to fix China’s economy, when it doesn’t even have a debt problem

Chen Zhao says Beijing has embraced the mistaken view that China’s economy is overleveraged. A large part of China’s high debt-to-GDP ratio is actually cheap credit given to the state sector. In fact, the private economy is underleveraged

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President Xi Jinping visits a workshop of China First Heavy Industries in Qiqihar, Heilongjiang province. Is the Chinese economy overleveraged? A large part of China’s high credit-to-GDP ratio is actually “credit” extended to state-owned enterprises. Such “credit” should be reclassified as Beijing’s fiscal outlays. Photo: Xinhua

Published: 2:02pm, 28 Nov 2018Updated: 10:26pm, 28 Nov 2018

The Chinese economy has been characterised by a stop-go pattern and policy flip-flops since 2010: a period of strengthening growth is always followed by a bout of monetary and fiscal tightening, which invariably leads to a growth slump and forces the government to reverse policy again.

The root cause of this curious economic back-and-forth is that the Chinese government has fully embraced the popular view that the economy is overleveraged. Thus, whenever business activity is strengthening, Beijing always quickly curtails credit creation to deleverage the economy, and it always backfires.

Is the Chinese economy overleveraged? Most people would answer “yes”, looking at the country’s high debt-to-GDP-ratio. However, this ratio is extremely misleading. Debt occurs primarily because savings need to be transformed into investment. For any economy, there are only two ways domestic savings can be intermediated into domestic investment: through equity markets or debt markets, including commercial banks.

Pedestrians are reflected in a stock board in Tokyo. Countries with high savings rates, like Japan, also have higher debt-to-GDP ratios. A high debt-to-GDP ratio is not always a cause for alarm. Photo: Bloomberg

While the United States allocates 70 per cent of its financial resources via its equity markets, most Asian and European economies rely primarily on banks for financial intermediation. This means that countries with very high savings rates will have significantly higher gross debt-to-GDP ratios than economies with lower savings rates.

In fact, there is a well-defined positive correlation between the indebtedness of an economy and its savings rate. For example, Japan, Singapore and South Korea all have very high levels of debt but have also had extraordinarily high savings rates for a long time. Importantly, these economies rely primarily on commercial banks or bond markets to allocate domestic savings. As a result, these high-savings economies have all amassed very high gross debt-to-GDP ratios.