China Debt, A Systemic Risk?

Chinese debt is often cited as a potential systemic threat to the global economy. Other culprits are deflation and Japanisation of Europe (the latter incidentally was dismissed by Rob Burnett, Head of European Equities at Neptune Investment Management in a recent webinar I listened to – but this is another story), tapering of QE and predicted interest rate rises. Although I think a stockmarket correction is more likely to come from profit taking or investors talking them themselves into a crash, the wall of worry theory, I want to cover the issue of Chinese debt. To this end it was interesting to read a recent report on this subject from ETF Securities a leading providing of exchange traded commodities. They produce high quality research and reports but clearly have a vested interest in China’s economy given the commodities market is highly correlated with it.

In the report ETF Securities compared debt levels to GDP across the world in the form of a bar chart. To remind you GDP or Gross Domestic Product is the sum of all the goods and services a country produces; effectively the output of its economy.  A debt to GDP ratio is a more important measure than total debt in monetary amounts, as a very productive economy can service a high level of debt. Top of the pile with highest debt to GDP, (debt is private sector including the consumer and government borrowing) was Ireland, bottom was Saudi Arabia. Countries with high debt to GDP ratios included Japan (2nd), Luxembourg (3rd) and Belgium (5th). Countries at the other end of the scale were Russia, Mexico, India, Indonesia and Argentina. As an aside this accords with the observation of generally low debt levels in emerging markets, one reason I favour this sector.

Back to China. Chinese debt to GDP was half way along the scale. It is not a highly indebted economy compared to Japan, the US or the UK, although debt may be under reported. However a unique feature was that Chinese debt was divided into government, local government and consumer debt. For all other economies the bar chart showed only government and private sector debt and this suggests Chinese local government borrowing is a particular feature of their economy. (As another aside, apart from Japan, in every other country government debt was lower than that of the private sector). Further local government debt in China exceeds central government debt. Most of the local authority debt is to fund off budget spending. This arose from fiscal reform in 1994 which shifted revenue away from local to central government. At the same time local authorities had to fund the same level of expenditure including infrastructure spending from the same tax revenue. Local government funding structures are complex and opaque as technically local governments are prohibited from borrowing directly. This led to them setting up companies called Local Government Funding Vehicles (LGFVs) to raise finance.  ETF Securities note:

The central government has recognised that local governments have debt financing needs and the charade of off-budget financing is untenable in the long-term…. Eventually we expect the government to bring in the necessary reform to allow local governments to raise bond finance more directly through something akin to the municipal bond market in the US.

The article also stated central government has already raised bond finance on behalf of some local governments and suggested further liberalisation and oversight of local authority debt but that local debt levels are likely to rise to meet annual growth targets. Rising leverage has risks but ETF Securities consider Chinese government debt is quite moderate and well below the levels considered excessive in other economies.

I conclude there are concerns about Chinese debt (including the shadow banking system*). The biggest issue for me is the lack of transparency, raising the question do we really know how bad and intertwined debt in China is? The role of complex, opaque and ultimately toxic CDOs (collaterized debt obligations) in the 2008 global banking crisis suggests caution.  However with high economic growth rates, large foreign reserves and central bank fire-power I somehow think the Chinese will remain in control of the problem. Time will tell.

*The shadow banking system in China is in contrast to state owned and highly regulated banks, who previously accounted for virtually all lending in China. Shadow banks are alternative providers of credit and include trusts, leasing companies and money market funds. They have raised significant concerns. An interesting article in the Economist you may wish to read is:

http://www.economist.com/news/finance-and-economics/21601872-every-time-regulators-curb-one-form-non-bank-lending-another-begins

The opinions expressed in this blog post are those of ETF Securities and my own. You should not make investment decisions based on them but should seek individual independent advice.