Why China Debt Bulls are Mostly Wrong
As the debate about the sustainability about the increase in Chinese credit has grown, a number of points have been raised about why China simply cannot have some type of financial crisis or even needs more debt. Though I believe a near term financial crisis is an extremely low but rising probability event, it is clear that the optimism about Chinese debt levels or growth ranges from misguided to uninformed. Let us elucidate some of these.
Myth #1: China has high savings rates. This is entirely true but does not change the fact that if firms cannot repay their debts, Chinese banks and savers will be harmed. A bank is an intermediary transferring surplus capital from depositors to borrowers and charging a fee for the service and risk incurred. If firms cannot repay their debts, this will place enormous pressure on banks to make depositors whole, and depositors will become decidedly unhappy if they incur losses. Even though China has established a deposit insurance scheme, this only means that bank losses will be imposed on many of the firms who cannot pay initially. Yes, China has a high savings rates, but if firms cannot repay their debts, there will still be large problems.
Myth #2: China does not owe foreign debt. Again, a mitigating factor for sure, but does not fundamentally alter the debt problems. The 1997 Asian financial crisis has programmed most to believe that foreign denominated debt or large foreign inflows is the driver. Financial crises can happen in the absence of a foreign driver. There are many examples of financial crises without major foreign influence. If firms cannot repay their debts, foreign or domestic, that only alters upon who the losses will be imposed and alters the probability for rapid outflows. If firms cannot repay their debts, they cannot repay their debts, and losses need to be imposed.
Myth #3: GDP growth remains strong. Leaving aside questions about the accuracy of official GDP growth, it cannot be stressed strongly enough that firms and governments do not repay debts with imaginary GDP credits but with cash flow. Based upon various measures of cash flow, corporations, the primary debt sector in China, are having enormous struggles with liquidity. From revenue growth that is flat to receivables growth rising double digits annually and an average of more than six months, there are significant cash flow problems in China hampering firms ability to repay debts. Even if GDP growth data is accurate, most of the corporate sector remains mired in a deflationary spiral with debt growth outpacing cash flow and revenue growth.
Myth #4: China can lower its debt servicing cost to international norms to manage debt. Many firms, including a major investment bank recently, pointed out that Chinese debt service costs as a percentage of GDP are high by international comparison. They noted that if debt servicing costs as a percentage of GDP were brought more in line with international standards, China could continue to expand debt levels. However, this analysis makes an elementary mistake: for China to lower its debt servicing costs as a percentage of GDP it must lower interest rates. Lowering PBOC interest rates, especially in an environment when the Fed will likely hike at the next meeting, runs the very real risk of ending the RMB/USD peg. Lowering debt service costs will place enormous pressure on the peg and if lowered much beneath its current level would likely lead to much bigger problems.
Myth #5: China should expand debt as a counter-cyclical tool to boost growth. In the absence of fixed exchange rate regime with capital controls, this would make some sense. However, rapid credit expansion and money growth outpacing nominal GDP by about two to one is a recipe for currency pressure. If China is going to continue to utilize this basket of economic tools, this will lead to the unceremonious end of the RMB/USD peg. You cannot do these things and maintain a currency peg.
Myth #6: China does not need to worry about bad debts as it can print money to buy bad debts. Semi-respectable people have put forth this mistaken notion as proof that the Chinese debt problem really is not a problem. Debt monetization is not a good outcome. This is like hoping for dengue fever rather than malaria. Furthermore, in China’s case would likely require the end of the RMB/USD peg which would present an even bigger list of challenges. Printing the money necessary to buy bad debts would increase the money supply which would place downward pressure on the RMB. Even just the announcement of such a policy would likely rile the currency markets which are already jittery. It is foolish to think China could execute any level of debt monetization without ending the RMB/USD peg which could unleash a whole range of other outcomes.
If you have not already picked up on it, probably the biggest mistake that China debt bulls overlook is that most of their outcomes or policies place pressure on effectively do away with the RMB/USD peg which is already under increasing strain. China has really tightened down capital controls of outward flows and inward flows are dropping rapidly.
While I do not believe a debt crisis is near term imminent for reasons I have already spelled out on numerous occasions, it is flat out wrong to believe the China debt bull story.