Does China have a debt problem? Yes and no, says a leading expert.

• Author: Lo, Chi

Debt arises when an economy transforms its savings into investment. The concern about China's debt is whether it is backed by domestic savings or by borrowed savings from overseas. Debt built on borrowed savings under an open capital account is more susceptible to financial instability. The financial structure of an economy also affects the amount of its leverage. So how much foreign debt does China have and how different is China's financial structure from that of other countries? Will more debt-fueled growth by Beijing only exacerbate China's excess capacity and delay the needed structural changes? How bad is this situation and what is the evidence?

Some observers argue that China's debt-to-GDP ratio, estimated at close to 250 percent in 2015, has reached a point that could trigger a systemic collapse soon. This ratio is high by international standards, but not as high as many have feared. It ranks only in the middle of the world debt league, according to data from the Bank for International Settlements, with countries such as Japan, Belgium, Portugal, Ireland, the Netherlands, and Greece recording significantly higher debt ratios.

HOW MUCH IS TOO MUCH?

Does China have too much debt? To assess this situation, let's go back to the basics. Debt arises when an economy transforms its savings into investment. There are two ways to do that, either through borrowing or through equity financing. If all national savings are transformed into investment via the equity market, the economy incurs no debt. In reality, there is always a portion of national savings being transformed into investment via borrowing either through bank loans or bond issuance. In this case, the economy builds up debt.

In a closed system, given a stable structure of financial intermediation between equity and debt financing, the higher the national savings, the higher the level of debt. So debt is bound to arise and there is nothing good or bad about it. Empirical evidence shows that there is a positive relationship between a country's national savings and debt level (see Figure 1). China is high up on the chart due to its high national savings.

However, in an open system, a country can borrow foreign savings from abroad. This means that it can build up an amount of debt larger than its stock of domestic savings by incurring foreign liabilities. Conversely, a country can accumulate foreign assets by lending its savings to foreign borrowers.

If a country lends more to...