China: Deleveraging is Hard to Do

“Financial security is an important part of national security and an important basis for the steady and healthy development of the economy.” President Xi Jinping, Reuters, April 26, 2017.

“Leverage comes by the pound and goes away by the ounce.” Zhang Zhongkai, Xinhua News Service, May 4, 2015.

For the first time in nearly three decades, Moody’s recently downgraded the long-term sovereign debt of China, lowering its rating from Aa3 to A1. As is frequently true in such cases, the adjustment was overdue. Since China’s massive fiscal stimulus in 2008, the government has experienced a surge in contingent liabilities, as its (implicit and explicit) guarantees fueled an extraordinary credit boom that continues today.

While the need to foster financial discipline is obvious, the process will be precarious. Ning Zhu, the author of China’s Guaranteed Bubble, has compared the scaling back of state guarantees to defusing a bomb. China’s guarantees have distorted incentives and risk taking for so many years that stepping back and allowing market forces to operate will inevitably impose large, unanticipated losses on many people and businesses. Financial history is replete with failed policy efforts to address credit-fueled asset price booms, such as the current one in China’s real estate. There is no safe mechanism for economy-wide deleveraging.

China’s policymakers are clearly aware of the dangers they face and are making serious efforts to address them. This year, authorities have initiated a new crackdown aimed at reducing the systemic risks that have been stoked by the credit boom. This post focuses on that policy effort, including the background causes and what will be needed (aside from good fortune) to make it work.

We begin by quantifying the surge in Chinese debt since 2008, when the country’s massive fiscal stimulus was announced. As a ratio to GDP, credit to the nonfinancial sector jumped to 257 percent at the end of 2016, up from 142 percent at the end of 2008; and (as Moody’s noted in its rating assessment) the upward trend persists (see chart). By this measure, China’s overall indebtedness exceeds that of the United States (253 percent), the G20 as a whole (237 percent), and is well above that of emerging economies (184 percent).

Credit to the nonfinancial sector (Percent of GDP), 2006-2016

Source: BIS.

While the aggregates are striking, it is China’s nonfinancial corporate debt that really stands out. At the end of 2016, in dollar terms, credit to China’s nonfinancial corporations topped the globe at $17.8 trillion, about a third larger than that of the euro area and half again the level in the United States. Furthermore, this portion of credit has increased the most since 2008, rising from 96 to 166 percent of GDP. Among the 45 economies for which the BIS maintains data, only three small ones (Hong Kong, Ireland, and Luxembourg) display a higher ratio of corporate debt to GDP. Relative to per capita GDP, China’s corporate indebtedness is an extreme outlier—roughly four times higher than economies with comparable per capita incomes (see following chart). No matter how you look at it, the conclusion is inescapable: China’s corporate debt is extraordinarily high.

Credit to the nonfinancial corporate sector (percent of GDP) vs. GDP per capita (PPP, constant 2011 U.S. dollars), 2016

Note: Each circle represents an economy, with the size of the circle proportional to the dollar value of credit to nonfinancial corporations. Sources: BIS for credit and World Bank for per capita GDP.

According to the OECD, more than two thirds of this corporate debt is owed by state-owned enterprises (SOEs). Both SOEs and local government financing vehicles (LGFV) that are used to finance infrastructure projects still enjoy privileged access to finance and—to an uncertain extent—an implicit government backstop. Many observers argue that, should a wave of defaults compel it to recapitalize financial intermediaries that hold much of this debt, China’s government can afford the losses. While this may be so, the urgency of ending the implicit guarantees, restoring financial discipline and enhancing the resilience of the financial system, is still growing.

Of key concern is that trend economic growth has fallen substantially, and that the medium-term risks remain on the downside. Comparing the experience since 2008, when the credit boom began, to the 2000-2007 period, annual economic growth in the recent period has averaged nearly 2 percentage points less. Much of the slowdown reflects lower total factor productivity (TFP) growth—this is the portion of economic growth that cannot be attributed to changes in labor or capital inputs. For example, various Conference Board measures of annual TFP growth have slowed by 1.1 to 2.5 percentage points over this period. A very different measure of TFP computed by Bai and Zhang from provincial data puts the slowdown through 2014 at 1.9 percentage points, near the midpoint of the Conference Board range.

Rather than filling in for this large and possibly worsening TFP slowdown, coming changes in capital and labor inputs probably will contribute to a further medium-term deceleration. Despite China’s ongoing urbanization, the growth of the labor force is slowing as the population ages. At the same time, the combination of China’s rising capital stock and the guarantee-induced distortions in credit allocation is lowering the impact of capital accumulation on output. Hence, a simple measure of China’s capital efficiency—the incremental capital to output ratio (which rises as the benefits of an additional unit of capital shrink)—has been setting new highs for several years (see, for example, Figure 17B in the OECD’s latest Economic Survey of China).  That is, it is taking ever more capital to produce each additional unit of output.

Rising debt combined with falling growth is a combustible mix. Financial vulnerabilities are the immediate result. Those that are the most apparent start with the increase in opacity of the system, including a surge in shadow banking. Assets of “other financial intermediaries” (excluding banks, insurers, pension funds and the like) have surged, expanding at an annual growth rate of 35 percent since 2007. By 2015, the level reached $7.7 trillion in 2015, accounting for nearly one-fifth of financial assets in China outside the central bank (see the Financial Stability Board’s latest Global Shadow Banking Monitoring Report).

Then (as nearly always), there is real estate. As Glaeser et al highlight, valuations are precariously high. Given the degree to which real estate collateral backs financial assets (including the debt of LGFVs), even if households are far less leveraged than the corporate sector, this is worrying.

And finally, there is the capitalization of the financial intermediaries themselves. A market-based measure of the expected capital shortfall in China’s financial system (conditional on a large, global equity market collapse)—the NYU Stern Volatility Lab’s estimate of SRISK—now puts China at the top of the global systemic risk rankings. As of mid-2017, China’s aggregate SRISK totaled about $650 billion, up from less than $100 billion before 2011. For comparison, note that U.S. SRISK has slipped below $200 billion, a mere fraction of the more-than-$900-billion peak in 2008.

Against this background, financial policymakers are clamping down in what is now widely described as a “regulatory storm.” Naughton traces the recent shakeup ultimately to Chinese authorities’ worries about financial volatility (including the 2015 equity market debacle) and to the aggressive behavior of some shadow banks. Following leadership replacements at the China Securities Regulatory Commission (CSRC) in 2016, and at the China Insurance Regulatory Commission (CIRC) and the China Bank Regulatory Commission (CBRC) this year, these key regulators have implemented a wave of reforms in an effort to put a check on shadow bank activities. The People’s Bank of China (PBoC)—typically first among China’s regulatory equals—has been working in the same direction. Naughton describes several significant changes: intermediaries must now report consolidated measures of leverage, and some activities viewed as especially risky (including shadow banking in insurance and online) are getting special supervisory attention. In addition to extending the regulatory perimeter, the screws also appear to be tightening on certain favored borrowers. As a result, reports speculate that the LGFV sector could experience its first default later this year.

This coordinated effort to contain systemic risk is, if anything, long overdue. But it faces major challenges. Perhaps most important, slower economic growth will likely result from the substantial tightening in financial conditions brought on by the combination of stricter regulatory oversight and higher central bank policy rates. China’s yield curve, which temporarily inverted last month, and remains very flat, is an early warning indicator of just such a slowdown (see chart).

China: yield gap between 10-year and 1-year government bonds (basis points, 2007-7 July 2017)

Source: Bloomberg China government bond yield indexes (GCNY10YR and GCNY1YR).

It is worth noting how steep the yield curve was in 2009-10 when both fiscal and monetary policymakers were acting aggressively (and successfully) to stimulate economic growth. No less important is that in previous periods of tightening, which also aimed to reign in financial excesses, the authorities retreated when diminished liquidity threatened growth prospects. The point is that, while regulatory actions that tighten financial conditions are necessary for securing long-run financial stability (and probably for long-run economic growth), the willingness of policymakers to sustain them will depend on their tolerance for slower economic growth in the short and medium term.

Another major challenge is the willingness of authorities to scale back the role of the state in the economy, especially with regard to SOEs. We recall that in 2013 the Third Plenum of the 18th Party Congress called for far-reaching supply-side reforms, including a “decisive role” for markets. Yet, so far, government efforts to implement SOE reforms have been disappointing (see Naughton, Maliszewski et al and Lam and Schipke).

Will this time be different? Will the Chinese authorities tolerate a temporary economic slowdown, the realization of large losses among SOE and LGFV debt holders (including systemic banks), and a speedier downsizing of weak SOEs, while promoting mixed ownership of (and increased competition for) other SOEs?  Will they embrace the cycle of destruction that naturally renews market-based economies?

Ultimately, the challenge of China’s regulators is to convince its powerful financiers (including those running the country’s most aggressive intermediaries) that they and their firms will suffer the losses that come from the risks they take. The goal is to compel these intermediaries (especially the most interconnected and opaque among them) to internalize the negative externalities that arise from spillovers of their activities on the financial system, much as pollution taxes discourage firms from dumping toxic waste (see, for example, Acharya et al).

Effective financial discipline requires such a link between risk and reward. Over time, greater discipline should lead to a more efficient allocation of China’s enormous savings. In theory, this will allow Chinese households to increase their consumption and reduce their saving rate, without sacrificing growth. But, after so many years of implicit government guarantees, it will probably take many years (and many business failures) to alter the mindset of the country’s systemic risk-takers. And, doing so without triggering a financial panic or a rapid economic slowdown involves threading what may be a very fine policy needle.

Success will require a credible regulatory system. Knowing this, a discussion already is under way in China about reform of the regulatory architecture itself. Should there be a “super-regulator” that unites the CBRC, CIRC, CSRC, and PBoC? Or, is it sufficient for one existing authority, presumably the PBoC, to take a more formal role in coordination? It is still early days, but the  post-crisis reforms in the United Kingdom—which, like China, has only a few key regulatory agencies—look to be doing a much better job of supporting coordinated policy than the extremely fragmented system in the United States. Yet, regardless of the regulatory architecture, the credibility of regulatory restraint depends to a much greater extent in China than in the United Kingdom on the perceived support of the country’s political leadership. Doubts about this support generally arise whenever other priorities—such as meeting short-run economic growth targets—are at risk.

Perhaps someday, we will view President Xi’s April 2017 elevation of financial security to the level of national security—as in the initial citation—as a turning point when China’s efforts to wind down guarantees and promote financial discipline became irreversible. After all, how could the rhetorical commitment to reform go higher? But old habits die hard. We are reminded of the experience with taming inflation in the advanced economies during the final quarter of the 20th century. After a long period of high inflation, it took sustained policy actions—often at high economic cost—to restore price stability. Changing the policy framework (like creating an independent central bank and adopting an explicit inflation target) may be necessary, but it is rarely sufficient. The same lesson applies to restoring financial discipline: to be effective, regulators will have to show consistently that their priorities do not erode in the face of short-term considerations. If the yield curve slope is a useful signal of cyclical prospects, the first real test of China’s “regulatory storm” could come soon.

Acknowledgement: We are grateful for very helpful conversations with Professor Barry Naughton, Sokwanlok Chair of Chinese International Affairs, University of California at San Diego.