Despite rising corporate defaults, China’s overall debt dynamics have not deteriorated. Its economic fundamentals appear strong enough to contain a debt-currency crisis. A closed capital account, debt self-funding, and a strong political will to cut debt should minimise systemic risk. China will likely allow market forces to play a bigger role in future efforts to reduce debt.
Slowing economic growth and rising defaults since the Sino-US trade war and Covid-19 shocks hit China have revived market concerns about the country’s debt sustainability.
Indeed, debt in the non-financial corporate, government and household sectors has risen sharply since the 2007-08 Global Financial Crisis, pushing total debt as a share of GDP up by a whopping 127 percentage points (see Exhibit 1).
We should note that the problem is not central government and recognised local government debt [1], which rose at the slowest rate among the debt categories and amounted to only 45.7% of total debt in 2020. [2]
Rather, implicit local government debt is the issue. Since there are no proper records, it is hard to quantify accurately.
Debt worries should not be exaggerated
While the concerns over debt levels are not new, China’s aggregate debt ratio is not as alarming as news headlines have depicted it. Many other countries have higher ratios (see Exhibit 2). The opening up of the capital account has aggravated worries over a debt-currency crisis, but China has markedly low external funding risk due to its strong external account balances.
China has continued to run a current account surplus and to attract foreign direct investment inflows. Steady inflows, prompted by the gradual opening of the capital account and inclusion of Chinese assets in international benchmarks, have bolstered China’s financial accounts. The sum of these inflows has kept China’s balance of payments in surplus, boosting the renminbi exchange rate and foreign exchange reserves.
High savings allow for self-funding
China’s foreign currency debt was only about 9.0% of GDP in 2021, compared with foreign exchange reserves of 24% of GDP, indicating that it can more than cover all its foreign liabilities. Furthermore, foreign reserves equated to more than twice the country’s short-term foreign debt and 13.5 months of import cover. This is significantly higher than the international safety standards of 100% of short-term debt and three months of import cover. On this basis, there is little risk of a debt-currency crisis in China.
China’s debt is denominated in local currency and self-funded by high national savings. In the absence of a developed equity market, growth has been financed by debt. This suggests that China’s debt ratio might not be as excessive as it appears due to its underdeveloped capital market. It also argues that while China has a debt problem, the risk is manageable.
Debt reduction and market forces
Beijing is not in denial of this risk, although it has been criticised for moving too slowly on cutting debt.
To improve transparency, it has attempted to quantify local government debt by launching national audits on local government financing vehicles (LGFVs) [3]. The central government has also formally recognised some LGFV debts since 2014, effectively putting hidden debt back on the government’s budget.
Beijing has taken measures to separate the LGFVs from local governments and turn them into independent economic entities or to close them down if they are insolvent. This reform will bring more off-budget borrowing back onto the official budget.
To resolve local governments’ ‘soft budget constraint’ problem, which was responsible for the huge build-up of local government debt, Beijing introduced a Budget Law in 2015 to rein in local government borrowing and put local budgets under the strict scrutiny of the Ministry of Finance.
In April 2021, it introduced new rules to bar local governments from raising any implicit debt in any form and requiring them to dispose of existing implicit debt and improve borrowing transparency by publishing regular reports. The central government now scrutinises all local government investment projects with a strict approval process to force local governments to adhere to their budgets.
The trend of rising defaults reflects Beijing’s resolve to retreat from implicit guarantees and enable market forces to pick losers and force them to exit the system.
It is President Xi Jinping’s reform objective to use the market as a strategic tool for economic liberalisation and structural reforms, so that market forces play a bigger role in future efforts to reduce debt and allocate resources.
A recognised and manageable risk
In short, we believe China’s debt is a manageable risk. What distinguishes China from many other countries struggling with debt is that its leadership has recognised the risk and has started to address it before it is too late. Evidence shows that Beijing’s deleveraging efforts have continued in tough times. [4]
Meanwhile, one could argue that China’s underdeveloped financial system has made its debt problem simpler to deal with.
[1] Since 2014, the central government has started recognising some local government financing vehicle (LGFV) debt as those authorities’ official repayment obligations.
[2] According to official data from the Centre for National Balance Sheets (CNBS), reported by CEIC, a database vendor.
[3] LGFVs are special purpose vehicles (SPVs) set up in the 1980s by local governments to skirt around central government borrowing restrictions and raise funds for local infrastructure and investment projects.
[4] See “Chi on China: When Structural Objectives Clash with Cyclical Forces”, 7 January 2022.
