Known unknowns

Everybody knows China has a debt problem. The hard part is getting a read on the size and distribution of the liabilities. Below are some key numbers, sourced from UBS:

  1. Total debt (excluding the central government) stands at 210 percent of gross domestic product (or GDP), yet the headline figure is misleading. The bulk of this debt is issued by state-owned enterprises and local government financing vehicles.
  2. Non-performing loans (or NPLs) in China stand at just 1.5 percent of GDP. Yet this low number disguises a number of fault lines. Recorded NPLs are rising at 30 percent to 45 percent per annum. Loans deemed overdue but not yet impaired doubled this year—a sign of negative corporate cash flows and further debt troubles ahead.
  3. The official numbers don’t include the biggest problem area: off-balance-sheet loans. Banks don’t hold capital buffers against these loans; instead, they treat them as investments. Total bad debts in the system amount to around 11 percent of GDP, UBS estimates.
  4. The problems are mostly concentrated in a few sectors saddled by overcapacity and changing regulations, such as stricter pollution controls. Infrastructure (22 percent of bank assets), manufacturing (16 percent) and real estate (at a likely understated 7 percent) are the main offenders. Caveat: Debt in these sectors is likely worse than it appears. The official numbers only cover the on-balance-sheet exposures of 70 banks.

Threats to the Chinese Economy: The Known Unknowns

Market Realist – The country’s burgeoning debt is one of the biggest threats to the Chinese economy today (ASHR). According to estimates from McKinsey, total borrowing had ballooned to a whopping 282% of GDP by 2014. Between 2007 and 2014, global debt rose by $57 trillion. Almost one-third of this figure was contributed by China alone.

As observed by McKinsey in its report earlier this year, this rapid debt buildup was the fastest ever among all emerging markets (EEM) (VWO). The pace of the surging debt levels was almost double that of the US (VTI) (IVV) and the UK (EWU) in the buildup to the 2008 financial crisis (IYF) (XLF). The previous graph shows the frenetic increase in the debt-to-GDP ratios of China (MCHI), and compares it to the current debt levels of other nations.

According to McKinsey, more than half of China’s new debt over the past seven years has been raised by the real estate and construction sectors. Now that the sector is witnessing a slowdown, there is serious cause for concern. According to estimates from McKinsey, the value of residential real estate transactions in 40 Chinese cities fell by 14% from April 2013 to August 2014 after increasing by an average of 26% for the preceding ten years. The housing slump could send the debt crisis over the edge by effecting a slowdown in the construction sector, leading to a rise in bad debt and a crisis in the country’s shadow banking sector.

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