Concerns about the level of debt in China continue, and the issue of default will be a major theme in 2014 given the large number of products reaching maturity.
China’s currency recently did something that it hasn’t done in a long time: In late February it began a sustained reversal of a pattern of appreciation against the US dollar that reaches back to 2005. This action was widely attributed to the People’s Bank of China (PBOC), which denies having anything to do with it.1 Opinions differ on whether the PBOC is proactive or reactive in this critical shift. There has been considerable upward pressure on the currency as investors sought to bring money into the country to take advantage of high returns and speculate on future currency appreciation. This fact vexed the central bank, and it was forced to acquire foreign currency reserves in order to stem the currency rise. Although there have been substantial inflows of short-term money aimed at arbitraging China’s high interest rates, long-term money has been flowing out at an increasing pace. High-net-worth individuals in China and corporates with free cash are said to be concerned about domestic overinvestment, excessive money supply growth, and troubles in the financial system. There is also concern that the actual inflation rate far exceeds the government’s published numbers.
Meanwhile, the PBOC has announced plans to widen the band around which the currency is permitted to move. Following the announcement, the renminbi fell almost 1.0 percent, one of the sharpest declines ever. It is possible, though uncertain, that the band will be further widened as the bank makes plans to allow freer trading of renminbi and freer cross-border capital flows. The ultimate goal, of course, is to make the renminbi a widely used trading and reserve currency. Yet for this to happen on a large scale, capital controls will need to end, and there will need to be a more transparent monetary policy. There continues to be talk about further liberalization, and the government has been resolute in not announcing any specific dates for key reform moves to be implemented. A major external force currently acting on the renminbi is the tapering of the US Federal Reserve’s liquidity operations and the resulting impact on returns outside of China.
Financial system woes
It has been reported that financial risk spreads in China are rising to levels not seen in many years. This suggests that there is a flight to quality as investors become increasingly worried about risks to the financial system. Indeed yields on Chinese government bonds have declined, which also reflects the central bank’s efforts to slow credit growth, especially in the shadow banking system. The volume of assets in off-balance-sheet vehicles has increased dramatically in the last year, and the volume reaching maturity this year will be far greater than last year. Credit continued to grow throughout 2013 at nearly twice the rate of GDP growth. Meanwhile, the fear of default is increasing, especially as China only recently averted default on a trust product when a large bank agreed to cover the losses. The expectation is that the government will not cushion another imminent default.
Does all of this mean that China faces a crisis? Yes and no.
The issue of default will be a major theme in 2014, given the large number of products reaching maturity, which is one reason for the increase in spreads. Indeed, credit default swap prices on banks have risen rapidly lately. Does all of this mean that China faces a crisis? Yes and no: Yes, there could be serious problems in the financial system. No, it is not likely to involve the failure of a large financial institution. A more likely scenario would be a government bailout of large financial institutions followed by a cutback in lending, leading to a slowdown in growth.
However, this is inconsistent with Prime Minister Li Keqiang’s plans. He recently announced a growth target of 7.5 percent, pledging that the government would continue investment to achieve it.2 This is both good and bad news: China’s credit intensity is now approaching five, which means five units of investment are required to drive one unit of GDP growth. The growing inefficiency of driving growth through investment could be problematic. Meanwhile, the headline growth number that China announces annually has itself been a major impediment to reform. China may have to engineer a slowdown in growth in order to resolve the imbalances in the financial system. To offset a slowdown in debt-fueled investment, it would make sense to implement measures designed to boost consumer spending.
What about debt?
Concerns about the level of debt in China continue. It was reported that nonfinancial companies in China have debt equivalent to 120 percent of GDP—a figure much higher than in most other major economies. The volume of such debt has increased 260 percent since 2008. The large amount of debt, along with a slowing economy and plenty of excess capacity in industry, raises questions about whether companies will be able to continue servicing this debt. China’s government does not generally let companies fail, especially state-owned companies, but will it be willing to absorb considerable losses in the future? If it does, what will it expect of companies in exchange? Perhaps it will demand restructuring in order to eliminate excess capacity; to some extent this is already under way. Perhaps it will impose restrictions on further borrowing. Clearly something has to give. The process of substantial restructuring of Chinese industry has been discussed for decades, but now is certainly a time when it is badly needed.
Local governments in China are crushed with debt, a situation that is worrisome for Beijing. As such, one of the options the government is considering is a reform that would make China Development Bank (CDB) the sole lender to local governments. The CDB is a government-owned policy lender that is already actively financing infrastructure development in China. The rumored reform plan would have the CDB evaluate loans and be the sole arbiter of whether local governments obtain credit. As such, it would allow Beijing to take control of the local government debt situation, which is now conservatively estimated at nearly 18 trillion Chinese yuan. While this reform would be a step in the right direction, it does not address the issue of what to do about existing debts that are likely to go bad. To address this, Beijing will probably need to provide some sort of bailout. Interestingly, there is a widespread belief that the accumulated debt is guaranteed by either the central or local governments—yet this is not the case.
EndnotesView all endnotes
- Bloomberg, “PBOC seen doubling yuan band next quarter amid global push,” February 28, 2014, http://www.bloomberg.com/news/2014-02-27/pboc-seen-doubling-yuan-band-next-quarter-amid-global-push.html.
- Reuters, “China aims for 7.5 percent economic growth in 2014: Premier Li,” March 4, 2014, http://www.reuters.com/article/2014/03/05/us-china-parliament-gdp-idUSBREA2400X20140305.