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Here’s Why the Tipping Point for China’s Debt is Coming

China’s debt has garnered attention again recently, with onshore debt defaults hitting record highs for two years. For years analysts have held the opinion that China’s foreign debt problem is containable whereas its domestic debt problem is somewhat a non-issue.

As of the end of Q3 2019, or just before the outbreak of Covid-19, China’s short-term external debt stood at US$1.2 trillion, just shy of 40% of its US$3.1 trillion foreign reserves.

The Guidotti-Greenspan Rule holds that a country should have a foreign reserve level at least equal to its short-term external debt, and hence by this standard, China’s foreign debt level appears to be within control.

As for the domestic debt problem, optimists believe that since these debts are denominated in RMB and the bulk of the debts are accumulated by state-owned enterprises (SOEs) – which have the implicit backing of the Chinese Government – China can always monetise these debts to ward off a debt crisis.

Why investors should monitor China’s debt

However, not all domestic debt problems are benign. Just because the sovereign country can monetise its debt does not mean that a domestic debt problem is a non-issue.

Look no further than the Global Financial Crisis (GFC) in 2008 to assess the damage a domestic debt problem can bring on financial stability and the economy.

Japan in the 1980s to 1990s offers another example of a prolonged depression that can be brought about by bursting of an asset bubble and domestic debt bubble. Yet the most alarming case study for the current debt issue faced by China is the Russian Sovereign Debt Default in 1998.

If it is even possible for a government to default on its sovereign debt, why isn’t it possible for SOEs, with implicit backing of the government only, to default on its commercial debt?

To examine the conditions for China’s debt situation to fall apart, it is vital to look at three key indicators of debt sustainability: concentration of debt, asset prices, and the fiscal budget.

Key metrics to watch

Debt concentration can be assessed from both a geographical and an industrial perspective. Geographically, China is a large country with a vast geographical discrepancy.

Just like regional differences matter in the US, geographical discrepancy is even more significant in China. And just as the US has a large number of state banks and community banks aside from the few dominant national banks, China too has a large number of city commercial banks and rural financial institutions on top of the large national state-owned banks.

Some argue that the sporadic banking panics that plagued the US during the 19th century and through to 1907 stem from the inability of regional local banks to diversify their loan portfolios across the country and hence across industries.

The same can be said about the current state of banking in China. In 2015, city commercial banks and rural financial institutions made up 23% of the banking assets in China (national state-owned banks made up 41%).

Understandably, much of the banking risk is concentrated at these local banks, with limited capacity to diversify their industrial and regional exposure.

Industrial exposure

In terms of industrial concentration, Chinese lenders are known to loan out extensively to real estate developers and construction companies.

Though more recent data are lacking, the concentration of loans in the real estate sector seems to have abated, with the proportion of loans to real estate and construction industries (as a percentage of total loans) falling from 10.2% in 2010 to 9.3% in 2017.

Perhaps the worst time of concentration of loan risk in specific industries has actually ended in China.

With that said, the domestic debt problem in China is far from a non-issue. Asset price is another point of tension. Japan’s debt problem became apparent as its asset bubble burst in the early 1990s.

Higher asset prices beget more debt as the more valuable assets are used as collateral to borrow loans. Conversely, as asset prices plummet, values of collateral become insufficient to compensate for the debt and banks begin calling on loans.

As the assets held by corporates and individuals are now worth less than the loans they borrow, many become insolvent, further dampening values of assets such as company stocks and leading to a downward spiral of asset and resulting in a debt crisis.

Housing and government debt in China

In the case of China, much of the collaterals are properties and land, which have soared in value throughout the past decade, enabling firms and households to borrow even more and sustain their debt through refinancing.

Recently, after years of continuous rally, average property prices have remained flat at around RMB9300/sqm since April 2019. If property prices continue to take a breather and even weaken in future, that can bring a catastrophe to the debt situation in China.

Yet perhaps the most imminent threat for debt sustainability in China lies in the swelling government budget deficit. Russia’s debt default in 1998 was hastened by an exchange rate peg and a rising fiscal deficit.

The Russian government could not control the fiscal deficit and therefore monetise it (print money to cover the deficit). Coupled with an exchange rate peg that the Russian central bank was willing to (or obligated to defend), foreign reserves were quickly depleted.

Despite a series of exchange rate reforms since 2005, China too (more or less) has a kind of currency peg, against a basket of currencies but chiefly the US dollar, Euro, and Japanese Yen.

Although the USD/RMB exchange rate is allowed to fluctuate within a 2% trading band around the daily central parity in what is dubbed a “managed float”, the People’s Bank of China (PBOC) often interferes in the market to stabilise RMB values or implement its revaluation/devaluation schemes.

Meanwhile, China’s fiscal deficit has been diving deeper after a brief relief during 2010-2012 and stands at 2.7% of GDP in 2018. Though China’s fiscal deficit level is still nowhere close to that of Russia (at 6.3% of its GDP in the year preceding its default), the situation is worth monitoring.

If China’s fiscal deficit continues to worsen and the appetite for Chinese government bonds deteriorates, China may as well need to monetise its fiscal deficit.

Foolish takeaway

Overall, the need to maintain an exchange rate peg will force China to deplete its foreign reserves, making even its foreign debt repayment vulnerable.

China will then be stuck between a rock – letting the RMB float and risk a currency crisis – and a hard place (of depleting its foreign reserves and risking a debt crisis).

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