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Financial Literacy

China’s Debt Mess… Worse Than Greece’s?

Yesterday, the yuan suffered its sharpest decline in over two decades, dragging U.S. stocks down with it. Today, China devalued AGAIN!

You’re probably wondering just what the heck is going on. Is China headed for a crisis? Let me share some eye-opening stats.

  • China is still a “command economy,” which means its banks grant loans to anybody the government points its fat finger at. Result: Assets (debt on the books) at China’s banks are ballooning. They rose from 9 trillion yuan – or $1.45 trillion – in 2008 to 30 trillion yuan – or $4.83 trillion – in June of this year.
  • The country’s overall debt has quadrupled in just seven years, from $7.4 trillion in 2007 to $28.2 trillion in mid-2014.
  • The real crisis might be in private debt. The latest Bloomberg data shows that the amount of outstanding loans to households and companies is soaring. It jumped to a record 207% of gross domestic product (GDP) at the end of June. That’s up from 125% in 2008.

If that last point doesn’t worry you, consider this: Greece’s debt is a “mere” 185% of GDP. In fact, by the measure of corporate debt to GDP, China is growing faster than any other top-15 economy.

Corporate Debt to GDP - Top 15 Countries

That’s not a prize anyone wants to win.

It Seemed Like a Good Idea at the Time

Why is this happening? Well, a big clue is that debt really jumped after 2007. And the 2008 global financial crisis hit China hard. Exports plunged. Beijing had to act. So, the national government unveiled a $586 billion package in November of that year to fund infrastructure, construction and social spending.

Talk about a building spree!

State companies and local governments piled in with add-on programs that became permanent costs. Spending ballooned beyond the capacity of regional government budgets. Sounds like a big problem, no? According to policymakers, economic stability was so important that even regional governments that were heavily in debt would be permitted to tap bond markets for the first time.

To handle those contracts, Chinese companies had to expand. And to do that, they went deeply into debt.

At the same time, China was experiencing a real estate boom. Corporations and individual investors took on a lot more debt so they could invest and speculate in real estate. But then China’s real estate bubble started deflating. Companies and individuals were left with loans for “white elephant” properties.

McKinsey estimated that – excluding the financial sector – close to half of China’s debt is directly or indirectly related to real estate. That’s about $9 trillion worth.

Enter the Stock Market Crash

Meanwhile, a lot of the infrastructure that Chinese companies and local governments invested in turned out to be ahead of its time, to say the least. The delivery rate of completed capital projects in China – which was 74% to 79% in the late 1990s – fell below 60% by the end of last year. This implies that nearly 40% of Chinese investment projects are either not finished on time or not completed at all.

And remember China’s recent stock market crash? Well, Chinese banks took a licking there too. They made questionable loans to “gray market” firms, which then loaned the money to people who wanted to play the stock market.

Since it’s a “gray market,” figures aren’t public. But Chinese interbank lending jumped 86% in June from January, hitting $6.6 trillion. Repos, or repurchase agreements, are short-term loans between companies collateralized by securities. So, that might be a good indicator of gray market activity.

Add it all up, and that’s why nonperforming loans on the books of Chinese banks keep going up. In the second quarter, the amount of bad loans in China’s commercial banking sector increased by 11% to 109 trillion yuan ($175.53 billion).

In May, China launched a new stimulus package designed to help local governments restructure trillions of dollars in debt. It’s a debt-for-bond swap program. Maybe that will help. Or maybe the local governments, once they get more breathing space, will go deeper into debt.

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“Pile On More Debt!”

After all, China recently announced that its “policy banks” (Agricultural Development Bank of China, China Development Bank and Export-Import Bank of China) are about to issue at least 1 trillion yuan ($161 billion) in special bonds and invest the money in yet another round of infrastructure spending.

So the Chinese answer to everything seems to be “spend more, and pile on more debt!”

But here’s a key question that can’t be written off so easily: What is China going to do with all this debt, anyway? At this point in time, part of the answer is sell it to investors overseas… maybe in the U.S.

Remember earlier when I told you how local Chinese governments have racked up enormous debts? Those debts are wrapped into what are called “local government financing vehicles” and then issued in foreign currency bonds… $3.9 billion worth of these bonds have already been sold this year.

You just have to wonder if the local governments are counting on bailouts from the central government if things go wrong.

Not a Crash, but a Problem

I’m not expecting China’s huge amounts of debt to implode. For one thing, the country has $3.65 trillion in foreign reserves. Those are some mighty deep pockets to dig into when times get tough.

But I do expect this Great Wall of Debt to remain a drag on the economy for some time to come. Many analysts are expecting the Chinese economy to grow at 6.9% this year. Considering the country’s huge amounts of debt and other factors, it might turn out to be less.

However, that’s not to say there aren’t good places to invest. Internet and mobile devices, for example, are markets that are expanding so quickly in China that it’s more of an explosion.

Just know that if you’re expecting China to take back its spot as the No. 1 engine of global growth anytime soon… you might be in for a rude awakening.

All the best,

Sean


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