Pity China’s Xi Jinping: he faces an economic conundrum that seems to defy resolution. Until recently, he and China’s leadership sought to reduce the country’s huge debt overhang. Now they have reversed course. As much as the excess debt threatens China’s economy and financial system, it has reopened flows of credit, because the economy has begun to slow and because the leadership understands all too well China’s weak position in any potential trade war with the United States. If that were not trouble enough, and it is plenty of trouble, it has also become increasingly clear that China’s debt problems unavoidably result from its approach to economic management.
Global financial markets are growing concerned about China’s debt excesses. Unlike the problems weighing on the United States, China’s difficulties have little to do with government debt. On this score, China looks comparatively good: Beijing’s outstanding debt amounts only to about 42 percent of the country’s annual gross domestic product, much less than American government debt, which now exceeds our national GDP. Nor does the problem lie with Chinese households, which seem to have managed their finances prudently. Rather, it is business borrowing, particularly borrowing by the country’s massive state-owned enterprises, that has upset the country’s financial balance. Debt from SOEs has soared more than 20 percent a year, on average, for the last ten years, bringing overall debt levels in China to more than 250 percent of the country’s GDP. Business debt alone amounts to 170 percent of Chinese GDP, up from 100 percent in 2008. The Chinese picture contrasts sharply with that of other countries. In the United States, for example, business debt amounts only to 75 percent of GDP, a level at which it has more or less held steady for the last ten years. In Japan and Europe, relative business debt levels have also remained more or less steady, hovering respectively at 100 percent and 110 percent of GDP.
This tremendous level of Chinese business borrowing unsurprisingly has raised concerns over defaults and the financial dislocations that they can cause. During the first half of this year, such failures had risen 35 percent from the same period in 2017. Questionable and non-performing loans as of early this year ran at levels 3.5 times where they stood in 2010. Lending risks have increased the number of firms that have to pay premium interest rates. Recent statistics put this figure as high as 74.4 percent of all Chinese businesses. The expense has cut into profitability generally and raised the portion of income that firms must dedicate to interest expenses. At last measure, Chinese businesses pay over 20 percent of income for this purpose, far above the 14.6 percent average in the United States, for example, and the 14.2 percent average in Japan.
At first, Beijing reacted with a campaign to reduce leverage. Those efforts hit their stride in 2016 and by 2017 began to show results. Business, including SEOs, slowed its pace of borrowing, and by early 2018, debt use had begun to fall, dropping 6.2 percent over the course of this year’s first quarter. But rather than rejoicing at the policy’s success, Beijing could only see a new problem: without a free flow of credit, Chinese firms began to suffer. Defaults rose dramatically. It has become apparent that many Chinese companies need easy credit to survive—according to the latest government statistics, their revenue growth halved between spring 2017 and spring 2018, and profitability fell by some 25 percent. Business investment rates slowed, too, dropping to their lowest levels since 1999.
So Beijing has reversed itself. The deleveraging campaign has ended suddenly, too. Officials in the last few weeks have relaxed the pressure on SOEs to cut back on borrowing and building. President Xi has publicly downplayed deleveraging and encouraged generous credit flows to sustain and expand domestic demand. The State Council, China’s cabinet, has stopped hectoring cities and towns to restrain borrowing and spending, encouraging them instead to accelerate projects that they had postponed during the last year. Beijing has decided to tolerate the debt buildup again, despite the dangers, because it simply can’t afford an economic slowdown under any circumstances—and because it worries, especially now, about the threat of a trade war with Washington.
China understands its own economic vulnerability on this front much more keenly than most American commentators. The Chinese have long looked to exports as an engine of growth; they set themselves up as a manufacturing giant and built up production capacities far beyond the needs of their domestic economy—putting themselves in a position where they need foreign buyers to keep their economic wheels spinning, factories humming, and people employed. Any interruption in foreign sales, for whatever reason, will stop this production machine in its tracks. As the country’s leadership learned during the 2009 recession, that’s an outcome that the country can ill afford. Back then, it was not trade war but recession in Europe and the United States that choked off demand for China’s surplus manufactures. Layoffs led quickly to social unrest, in no small part because China maintains what can only be described as a thin social-safety net. The unrest led to widespread rioting that at times required the regular army to quell. Now, facing a different reason for an exports shortfall, Beijing is eager to avoid a replay of 2009. To buy peace with its own workers, it has turned to credit flows, looking to create enough domestic demand to substitute at least partially for the loss of exports.
If debt tradeoffs point up a weakness in China’s export-oriented development model, they also point, if obliquely, to a more fundamental flaw in its economic approach. Because China is Communist and has a Communist legacy, it uses centralized economic decision-making. Its planners, not the free market, decide what the economic emphasis will be. The SOEs, also a Communist fixture, dutifully follow these directives, marshaling impressive resources at great cost to pursue them. Such efforts frequently dazzle Western journalists and other observers. When the planners are right, these efforts produce impressive returns. When, however, market preferences change or technologies shift, as they frequently do, these concerted Chinese efforts create useless over-capacity and a huge accompanying debt burden. Successive misjudgments of this kind have created layer after layer of debt in a pattern that seems built into China’s system.
Of course, market-based systems often overextend themselves, too, as the real estate debacle of 2007-2008 and the ensuing recession remind us. But the fear of loss and the threat of bankruptcy bring discipline to market-oriented enterprises and keep them from going as far or as aggressively as their Chinese counterparts, especially the SOEs. And because firms can fail more readily in a market-based system, the debt overhang created by the excesses gets resolved relatively quickly. In China’s SOEs, by contrast, it just hangs around, while the enterprises borrow yet more to build for the planners’ next preferred project. The different dynamics go far to explain why corporate debt as a percentage of GDP in the U.S. and other market-based economies is today no higher than in 2008, while in China, as noted earlier, it is more than half again higher.
For all the debt, the financial crisis that many observers fear is not especially likely. Most of the overhang lies with the SOEs, and Beijing can cover for them if one or the other comes too near insolvency. After all, Beijing has tremendous borrowing power to put at their disposal. But even if China can avoid a financial crisis, the existence of its debt burden and the changing government response to it should underscore this seemingly unstoppable economy’s extreme vulnerability to trade friction and to the pitfalls of central planning—and serve as an object lesson for those here in the United States who would steer our economy toward such practices.
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