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Containers and trucks are seen on a snowy day at an automated container terminal in Qingdao port, Shandong province, China. Photo: Reuters

China’s unsustainable debt levels may trigger large-scale corporate defaults, OECD warns

  • Corporate debt in China stood at 155 per cent of gross domestic product at the end of second quarter of 2018, much higher than other major economies
  • In effort to contain the effects of US-China trade war, government has put deleveraging campaign on hold

Risks of large-scale corporate defaults are mounting in China, despite economic growth that “remains robust by international standards”, according to a new report.

The Paris-based Organisation for Economic Cooperation and Development (OECD) found that sagging domestic demand and weak export orders have led Chinese authorities to swiftly resort to stimulus measures, through expansionary monetary policy, tax cuts and infrastructure spending.

The OECD is an influential intergovernmental economic organisation with 36 member countries. China is not an OECD member.

While China’s stimulus, estimated at as high as 4.25 per cent of gross domestic product (GDP) this year, could lift growth in the short term, it could build up further economic imbalances down the road, the OECD said in its Economic Surveys: China 2019 report.

The OECD has warned China that it should not abandon its deleveraging campaign, despite the economic headwinds it faces. Photo: Shutterstock
State-owned enterprises (SOEs) have accumulated unsustainable levels of debt. The stimulus risks reversing years of progress in the government’s campaign to rein in the risky shadow banking sector, the report said.
Corporate debt in China stood at 155 per cent of GDP in the second quarter of 2018, which is much higher than in other major economies and unlikely to be sustainable, the OECD said. By comparison, Japan's corporate debt level is 100 per cent of GDP and the US’ is 74 per cent, respectively.

“Slowing growth and increasing costs of financing make it harder to service debt and can lead to further defaults, adversely affecting bank profitability and leading to liquidity problems,” the report’s authors wrote.

Investment in local infrastructure projects could also lead to a misallocation of funds, which would lead to financial instability in local regions, and eventually weaken growth.

In the past, local governments have often allocated capital to inefficient and overinvested segments of the economy at the expense of areas that actually need it, for example, building small airports while neglecting important urban development.

The People’s Bank of China has engaged in a series of stimulus exercises that the OECD warns could have negative impacts on China’s economy. Photo: Reuters

Meanwhile, tax cuts could lead to lower local government revenue, placing further burden on administrations that are already heavily indebted.

In 13 provinces, meanwhile, public debt exceeded total government income in 2017, with Guizhou, Inner Mongolia and Anhui being the three highest. Local debt exceeded a third of local GDP in eight provinces and in two, Guizhou and Qinghai, exceeded half.

The lowest branches of government in China typically have to deliver most crucial public services. In Communist China, these services are much more expansive than in OECD countries.

Local government covers around 95 per cent of public sector education spend in China, compared to around 28 per cent in Switzerland and just 16 per cent in Germany. In the health care sector, this rises to close to 100 per cent, well above the 4 per cent found in Switzerland and 3 per cent in Germany. In China, local government covers almost 96 per cent of total public sector spend on social security, compared to 19 per cent in Switzerland and 36 per cent in Germany.

Tax cuts, therefore, can restrict local authorities’ ability to cover such costs and lead to accumulation of debt.

The OECD suggested that China should accelerate its deleveraging campaign rather than reverse it, which the government has started doing in an effort to stave off the impact of the US-China trade war. In particular, Beijing should focus on removing debt from SOEs, which distorts the spread of credit through the economy, and creates excess capacity in industrial sectors.

Despite high corporate debt levels, defaults remained at a low 0.4 per cent of outstanding bonds at the end of July 2018 because SOEs and other public entities enjoy implicit guarantees from the government and other forms of preferential treatment.

Implicit guarantees should be gradually removed to SOEs by allowing them to default in an orderly manner, the OECD said. That would be necessary to let unprofitable local government investment vehicles fail, and lead to more efficient resource allocation.

Investment vehicles in some provinces, such as Jiangsu, Tianjin, Chongqing and Beijing, have issued debt levels that are close to or even exceeding local debt. In some instances, the debt issued by the government vehicles are worth more than half of total local revenues.

“While official public debt is not particularly high, future debt relief to local government investment vehicles could potentially derail it from a sustainable path,” the report read.

This article appeared in the South China Morning Post print edition as: Risks from corporate debt, state stimulus ‘on the rise’