China's Faustian bargain: an extraordinary debt bomb?

• Author: Lo, Chi

Worries about China's debt blow-out, which would potentially send Shockwaves across the global economy, have emerged again, with many financial market players and the Bank for International Settlements warning that China's private sector credit growth has accelerated to a potential crisis point.

Yet China's "credit bomb" has not gone off despite decades of similar expert warnings. Indeed, China is still many years away from a potential debt/banking crisis for several good reasons. The true concern is whether Beijing is entering into a Faustian bargain that trades the short-term gains of limited economic growth today for the long-term pains of diminishing investment returns tomorrow.

China's debt problem does not stem from its household and public sectors (their debt stood at 35 percent and 44 percent of GDP, respectively, in 2015); it stems from the corporate sector. Bank for International Settlements data show that China's non-financial sector debt grew at an annual rate of 18.1 percent between 2010 and 2015 to more than 160 percent of GDP, a level that was even higher than that of the United States. While state-owned enterprises were the major borrowers, many private-sector property developers were also among the most highly leveraged Chinese companies.

CHINA'S PRIVATE-SECTOR DEBT

Many analysts associate China's private credit with corporate debt and define China's total private credit as bank credit plus corporate bonds. Some have argued that China's private credit has grown larger than that of the European Union and that the situation had gone out of proportion since China has much lower per capita income than the European Union. However, this commonly used definition of China's private credit is wrong.

About 60 percent of Chinese corporate bank loans are extended to the state-owned enterprises and about the same share, if not more, of the so-called corporate bonds are issued by the local governments and their financing vehicles. True private-sector credit, as approximated by bank loans to the small- and medium-sized companies, has been stuck at around one-third of total bank lending, despite years of official rhetoric about expanding private-sector loans. The share of private credit is higher if one includes shadow bank lending, and this is where the true financial stress lies; but it is not yet fatal.

The problem with analyzing China's corporate debt is the confusion between its private sector obligations and it public sector debt. The definitions are indeed iffy. In China, a large share of company borrowing that is often counted as private sector is actually lending to the...