CHINA'S BRIMMING DEBT CRISIS

Let us start from where it all begin.

It is the beginning of 2008; the world is now aware of the looming financial crisis. China, which holds
$2 trillion in foreign reserves and $30 billion in trade surplus, is now prepped to deter most of the
shockwaves that will be coming its way. Its strategy is to steer clear of international bailouts and
focus on internal growth.
It started off by putting money into the state-run banks, cutting off interest rates (↓ 2.1 points) and
providing huge tax rebates (particularly in housing which has paved way for the real estate fallout).
Then in November '08, it announced the plans for a $600 B economic stimulus with an aim to boost
infrastructure and social welfare by 2010. The plan worked, as China's GDP growth accelerated to
10.6% [since 9.6% in 2008]. Over the next five years, it went on to lend an approximate of $15
trillion.

China was able to recover from the financial crisis but the reforms taken during this period, that
were supposed to encourage lending, became an underlying factor or the stepping stone for a
potential debt crisis. The data for the first quarter this year showed China's total debt crossing 300%
of its GDP, which until 2008 stood only at 150%.

While after the GFC, aggressive lending was common across all the countries, and some of which like
India have already started to see those seeds bear fruit; what makes China stand out is the
composition of its' total debt (corporate, household, government). The corporate component of it,
accounts for an astonishing 60 per cent; Here’s how other economies perform on this scale.

Corporate Debt as a % of GDP

180.0%

160.0%

140.0%

120.0%

100.0%

80.0%

60.0%

40.0%

20.0%

0.0%
2006 2008 2010 2012 2014 2016 2018

China United States Japan Eurozone

Source: Bank of International Settlemennts
[Of the $20 trillion corporate debt, 1/3rd of it is off-balance sheets, i.e, outside the purview of the
state oversight. Issued by a large number of small unregulated NBFCs or shadow banks, most of this
credit is given at relaxed conditions, below the nominal rates, making it really unsafe. Since 2007,
the shadow banking sector has multiplied by over 15 times [$8.4 T in 2018] and is an important piece
of the puzzle to understanding why the Chinese debt has skyrocketed.]

Citing the economic slowdown and the trade war, the government has pushed banks to lend more
to encourage consumption and growth. It is trying to subdue the hit to its exports by increasing
domestic consumption.
Heavy investments into the infrastructure and industrial sector by the banks has created new jobs
and lifted up the GDP but it has also created overcapacities (due to a weak demand; the YoY
consumption variance in 2017 stood dim at 6.4% as compared to 8.6% in 2016) and left many
companies with active production but no profitability to show. Also known as zombie companies,
they keep taking on debt with just enough to survive and cover their costs. A side effect of which is
that of the total new debt that was take last year, 30% of it was for the purpose of previous debt
repayment.

China in the recent years has become conscious of the problem it faces and has taken the following
corrective measures:

 The local government financing vehicles (LGFVs) will now only accept projects that can
generate considerable cash flows.
 The government initiated a debt-for-bond swap program which allowed the local
government to exchange high-cost loans for lower-cost bonds, thus reducing the overall
outstanding debt by spreading the debt over a longer term.
 It is cracking down on corruption, shadow banks and speeding up the debt recovery process.
- This year, the Public’s Bank of China (PBoC), in an effort to contain the credit risk, took
over the Baoshang Bank (with an NPA ratio of 1.7), the first bank acquisition in over two
decades.
 In its current Five-Year Plan, it has set out to reduce the overcapacities in the coal and steel
industry by by 10-15 per cent.

What else it could do?

 China must make the change from a manufacturing-based economy to a service-based

economy. The former model is no longer sustainable. The tertiary sector already represents
52% of the GDP. Recognizing this change and shifting from an exports-centred economy is
important. It would also provide the country with a new set of jobs that it so desperately
wants.
 It must disclose the official and corrected figures and statistics w.r.t. the debt burden for
speculators and management to make better decisions. A 1.75% NPA loan ratio [as reported
by the PBoC] is hardly believable considering the size and quality of China's debt. Some
economists say that the actual figures can range as high as 50 per cent.
 It must reduce its reliance upon firms like the China Cind Asset Management, which acquire
distressed assets from the state banks for the sole purpose of disposing them at trashy
prices. It helps the banks paint a rosy picture of their portfolios to the investors. Lately,
CCAM’s acquisition rates of such assets has far exceeded the rate at which they can dispose
them, thus incurring terrible losses which has thus far gone ignored.
  If China should want to reduce the impact of the seeming debt crisis, it must avoid bailing
out troubled banks and let them default. Letting the markets play it out themselves rather
than shifting the burden, will be an important step in ensuring a swift mess-clean up.

However, some economists do argue that the Chinese debt crisis will not happen and can be
controlled by the central bank. Ray Dalio of Bridgewater Associates, recently mentioned in an
interview(link) that the Chinese government as compared to the US has more command over its
monetary policy, meaning it could always restructure the debt of the banks as sovereign debt, write
off the bad loans on the banks' books and recapitalize them or push the debt repayment onto a
future date. China has the policy tools, financial resources and the will to do so.

Bottomline to this problem is creation of jobs and growth; As long as the Chinese government can
evident these two, it won't change its current policy. These two factors help the government avoid
social unrest and discourse. But as these two golden geese start to slip away, we can see the
government intervention steadily increasing.

The chances of a debt crisis are high but the government is also equipped to absorb all of the debt if
the time comes because a financial/ debt crisis essentially threatens its' Communist rule.

Update: In latest developments, it was revealed that over 200 corporate bonds had defaulted in the
past year. While this may sound alarms for any other country, this is actually a good thing for
Chinese economy, considering how in the past decade, defaults were rarely heard of. It means that
the government has recognized the urgency of the matter and is not turning a blind eye to it. Though
it is to be noted that most of these defaults originate from the crackdown on shadow banks. A
default-savvy approach has yet to find its way into the government’s core strategy.