Where Does China’s Debt Risk Burden Lie?

Market concern has tended to focus more on the rapid increase in leverage that has been seen in China since the global financial crisis. Although we agree that this is a significant issue that will likely necessitate some hard decisions, we think that there are serious differences in the nature of that debt and the management of the economy that could prevent a systemic crisis in the foreseeable future.

Much of the debt risk concern is around state-owned enterprises or SOEs. Privately owned enterprises tend not to carry as much debt. According to estimates in a paper published in June 2016 from Shi Kang, an associate professor at Chinese University of Hong Kong, private companies cut debt to 53% of assets in 2013 from 58% in 2007, while SOEs have seen those figures jump to 62% from 55%.

Since the global financial crisis in 2008, China’s debt concern has increased. China (FXI)(CNXT) landed itself in massive debt to revive its economy. China’s dependence on external debt has caused a sharp increase in external borrowing. Since 2008, total debt (which includes government, household, and corporate debt) has risen to about 250% of GDP, up 100 percentage points since 2008 as per NBS data. The chart above shows China’s rising debt burden. The Bank for International Settlements stated that China’s mounting leverage could indicate a financial crisis. Data from credit ratings agency Fitch Ratings show that the total debt along with corporate obligations is on target to reach 253% of GDP by the end of 2016.

The leverage ratio is a standard measure of a business or country’s financial stability. The debt-to-equity ratio is a common measure of leverage, the ratio of total liabilities to common equity. China’s major debt risk concern lies around SOEs. Since the global financial crisis, private firms have lowered their leverage ratios, which have fallen from 125% to 55% in 2013. SOEs’ leverage ratios have been steadily rising, as the chart above shows. Real estate and construction sector SOEs, which normally have a higher leverage, have contributed to the overall increase along with local SOEs in mining and utilities (Source: IMF).

If you look at the bigger picture, you see that on average, private sectors have already started deleveraging as part of China’s structural reform objectives for 2016. SOEs are the main concern currently, and IMF analysis suggests corporate restructuring and governance reform for SOEs could help with the higher debt issue. A comprehensive, proactive strategy can help China address the debt problem.

In the final part of this series, we’ll discuss China’s transition to a new economy and what you can expect from this change.