China’s public debt ‘a Damocles sword’

A likely explosion in the estimates of China’s public debt, which has so far been “vastly underestimated” by the market, is a “sword of Damocles” that hangs over China, and could rattle the market whenever it tumbles out of the closet, cautions a market strategist.

“Fiscal risks in China are underestimated due to the opacity of the debt structure, particularly at the local levels of government,” says Jean-Charles Sambor, lead Asia strategist at TCW. And although there is little risk of a systemic financial crisis in China, even if the worst-case scenario estimates of bad loans in local government investment vehicles come true, it would shake the foundations of market consensus that China’s public finances are on a robust footing, he adds.

The problem that Sambor cites is one that has caused much disquiet among analysts of the Chinese economy.

It relates to the shadowy finances of local governments in China, and banks’ reckless lending to them as part of the frantic rush to boost GDP growth in China following the global economic slowdown in 2008 (‘A $1.2 trillion timebomb ticks in China’, March 27, 2010).

According to official statistics, China’s public debt-to-GDP ratio is only 20%, as compared to nearly 100% in some European and other Western developed economies, and nearly 200% in Japan.

But that, says Sambor, is a misleading number. If all the debts of local governments in China and the contingent liabilities of the central and local governments are added up, China’s public debt to GDP ratio could rise to between 50% and 80% of GDP, he notes.

“From a market perspective, it will be taken as a major bad news if all of a sudden you have to change all the charts and forecasts and say public debt is not 20% but 70-80% of GDP,” says Sambor.

“Overnight, people have to change their minds and see China as a country with a ‘new normal’ level of public debt.”

Other economists and analyst, however, say that people who worry about a public debt crisis in China are looking the wrong way. “I’m mystified as to why people are obsessed with this debt issue,” says Arthur Kroeber, managing director of GaveKal Dragonomics, an independent research firm.

Kroeber recalls that between 2000 and 2005, “every investor I talked to” was worried about the prospect of a financial crisis in China. “They never asked me about the risk of a financial crisis in the West, and the reality is that we had one in the US.” Similarly today, he says, people say the public debt issue in China is “terrible”, whereas in fact, it should be the situation in the West they should be worrying about. 

“The purpose of debt,” say Kroeber, “is to finance stuff where there is a high upfront cost and the return comes much later.” In China, which has a structural growth rate of 8%, debt has been used to finance infrastructure — which will generate future cash flows. On the other hand, in the US and other Western countries, which have structural growth rates of 2-3% public debt levels are way higher.

“And that debt is being used mainly to finance social welfare spending, which produces no cash flow whatsoever.”

UBS China economist Wang Tao reasons that for China “will face a problem in the future” when it has to bring the banks’ bad loans onto its books, but the sustainability of its debt “is not an issue”, given the high savings rates and high growth rates.

In 2008, China’s banking system, having gone through a painful recapitalisation procedure, had a clean sheet. But in the last 18 months, “we’ve seen a huge credit expansion”, some of which, she reckons, will turn out to be bad loans. Over the medium term, the banking system will have to absorb it, but given that the economy will still be growing at 8%, “we don’t think a banking crisis.”

More broadly, says Wang, those who talk of a crashlanding of the Chinese economy are wrong on two counts. For one, they are wrong to extrapolate from last year’s unsustainable levels of credit expansion. “It’s true that if last year’s level of bank lending is kept up, there will be big trouble. But things have already turned around.”

Secondly, adds Wang, it isn’t right to deduce that China has an overinvestment problem by comparing it with Japan or the US. China is not in the same stage of development as the other two countries. “China is going through a rapid phase of industrialistion in the way that Japan did after the Second World War and the US did before the First World War. So if you want to compare, you must compare it those countries in that stage of development.” And the argument that China has a better infrastructure than other developing countries - and argue that any further investment in infrastructure is wasteful - too is fallacious. “It’s like saying someone is too rich because he or she is richer than most other poor people.”

Wang concedes that China does face some risks of a property bubble in the medium term if it does not address the structural drivers that feed local governments’ excessive reliance on land sale revenues. But the risk, she reckons, is not in the short term because credit is more or less under control, and measures to restrict investments in the property sector have already been initiated and are working.