In 1978, one year after taking control of impoverished China, Deng Xiaoping declared “to get rich is glorious.” Since Deng’s declaration, China’s per-capita GDP has grown by over 5,000%.
China is without question the biggest economic success story in recent history. However, rapid growth has come at a cost. China’s total debt/GDP ratio is now a staggering 277%—and the credit expansion is showing no sign of slowing. New bank loans in 2016 totaled $1.84 trillion—8% above the previous record.
Although the economy grew by 6.7% in 2016, the debt is causing a host of problems in China.
While government and household debt “only” add up to 65% of GDP, non-financial corporate debt now sits at a staggering 170% of GDP. So where is all the money going?
As the financial crisis caused exports to plummet, local and provincial governments created hordes of state-owned enterprises (SOE) to keep the economy moving. These SOEs now account for around 40% of China’s industrial assets. Combined, they are the size of Germany’s economy.
The spending spree softened the blowback from the crisis, but ended up funding unproductive projects (like the building of “ghost cities”). As a result of the debt-fueled binge, around 55% of total corporate debt belongs to these SOEs.
The good news is that China now has some of the world’s best airports and railways. The bad news? Bills are coming due for these grand projects, and the money isn’t there to pay them.
In 2016, around 25% of China’s largest 1,000 firms owed more in interest than they earned before tax. While only a handful of SOEs have been liquidated, bond defaults increased five-fold last year.
Many of these SOEs are now zombie companies—bankrupt but kept alive by a steady drip of credit. A 2014 audit of SOEs found that 20% of recent loans were taken out to pay older ones.
So where have these SOEs been getting the money from?
Lurking in the Shadows
Over 30% of all new loans since 2007 have originated from China’s shadow banking system. Moody’s estimated China’s shadow banks have $8.1 trillion in outstanding loans—over 70% of GDP.
Local governments have accounted for much of this borrowing, financing SEOs with the funds. Since 2014, local government borrowing has increased by 53%.
To generate revenue, China’s shadow banks have also been selling investment instruments called wealth-management products (WMP) to investors. WMPs are uninsured financial products that invest in assets ranging from real estate to corporate bonds. They offer investors higher returns, upward of 10%, and are regarded by many as having the implicit backing of banks or local governments. Given their attractiveness, more than $4 trillion has been invested in WMPs, and they are now included as part of China’s central bank’s regular assessment of risk.
Although money has been pouring into these products like into an AAA-rated bond, they are anything but.
These products contain risky assets like junk bonds and mining equities. Also worrying is that WMPs are now investing in one another. As such, they have been likened by some to Western lenders’ exposure in the subprime crisis.
Layers of liabilities accreting on the same underlying asset mean any defaults could spiral into a full-blown crisis. And it’s not only shadow banks who have exposure to these products.
As WMPs can be held off balance sheet, they have exploded as a new source of revenue for banks. In 2016, China’s largest 32 banks, which own 70% of bank assets, held around 20% of their loans off balance sheet. Banks have also been moving “bad loans” into WMPs to clean up their balance sheets.
The shift away from bank deposits and the interconnectedness leaves China’s financial system on much less solid footing. China withstood the Asian financial crisis in 1997 and 1998 and the global financial crisis in 2008 and 2009 in part because its financial system depended on highly stable household and corporate deposits parked at huge, government-controlled banks.
Although there haven’t been any major defaults thus far, that may be about to change.
While the official non-performing loan (NPL) rate for China’s banks is 1.75%, the real figures are much higher. The IMF puts the percentage of “loans at risk of default” in China between 10% and 15%. Ratings agency Fitch estimates it’s somewhere in the region of 15–21%.