Yukon Huang
Huang is a senior fellow in the Carnegie Asia Program, where his research focuses on China’s economy and its regional and global impact.
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Concerns about China’s ballooning debt indicators have been cycling on and off for nearly a decade. BIS put out an alert in September about China’s increasing “credit to GDP gap,” a warning that the pace was excessive relative to historical trends. Add to this worry the dependence of some banks on wholesale borrowing and re-emergence of shadow-banking and it is easy to understand why some observers have raised the possibility of a destabilising “Lehman moment.”

Yet predictions of an imminent collapse seem to come and go with the seasons. Part of the explanation is that China’s debt is largely the result of state-owned banks lending to state entities. Given the government’s strong financial position, there is less risk that isolated defaults or bank runs could derail the financial system. China’s problem also differs from other crisis cases because of the unique role that escalating land prices have played in shaping debt indicators and asset values.

The impact of rising land prices is unique to China because an extensive private property market only emerged after housing was privatised and land auctions were initiated a decade ago. In the aftermath, credit expansion supported a fivefold increase in land prices in the major cities (eightfold in dollar terms). This in turn has caused fixed asset investments to soar from 45 to 80 per cent of GDP. But what counts as investment for GDP purposes is gross fixed capital formation which excludes the value of land and transfers of existing property and as a share of GDP has hovered around 45 per cent. While the credit surge has driven up debt indicators, it has not spurred GDP growth.

Nevertheless, the credit expansion has contributed to what economists often refer to positively as “financial deepening” as markets are discovering the value of land based assets (housing and commercial property) formerly hidden in a socialist system. This suggests that the debt problem might be overstated. A more informative risk indicator might be the ratio of debt to asset values. This ratio was highlighted recently by Nomura analysts. As seen in Figure 1 (below) this ratio has been declining steadily over the past decade because of the increasing value of land based assets, even as the debt-to-GDP ratio has soared. Whether this might eventually trigger a financial crisis depends on the sustainability of these asset values.

Two groups have been affected: households and enterprises. In the case of households, housing affordability as measured by the ratio of personal incomes to housing prices has been improving and excess inventories have been declining. Thus the possibility of a major collapse in housing prices is low. Even if housing prices did fall significantly, most households have built up substantial equity positions backed by substantial savings, so the likelihood of a destabilising impact on the financial system is limited.

But rising asset values can have significant negative implications for enterprises if returns on these assets do not keep up with debt servicing costs. Profitability is not yet a generalised problem for private companies whose returns on assets are currently about twice that of state-owned (see Figure 2). Before the financial crisis, however, rates of return for the two groups were nearly the same. The divergence came from the government’s periodic stimulus efforts which led to an excessive expansion in the production capacity of selected state firms.

A consequence has been the emergence of a group of state-owned enterprises, referred to as “zombies,” that are generating huge losses. These are typically large companies operating in heavy industries, energy and construction related activities. The bad part of the problem is that most of the affected companies are concentrated in the already depressed “rust belt” regions making the solution politically more difficult. In some cases, potentially hundreds of thousands of workers need to be relocated and entire towns may become non-viable. The good part of the problem is that this is not a widespread phenomenon affecting the vast majority of companies which are private.

The authorities reissued instructions in October to have these zombie companies go bankrupt and their assets liquidated. The needed restructuring is now under way with some recent double-digit cuts in coal and steel production, recapitalisation of banks and outflows of workers to other regions. The increase in defaults suggests that the authorities are taking things more seriously. This has elevated producer prices to positive levels after years of decline. The result is an uptick in profit margins and increasing corporate revenues.

In sum what is seen by some as a generalised debt problem is actually more of a restructuring issue involving downsizing of a subset of state-owned enterprises. But much more action is needed in this regard before one can be confident that the worst is over.

This article was originally published in the Financial Times.