By Invitation

China's great policy dilemma: More growth or less debt

Artificial stimulus and growth spurts have had their day. An L-shaped, less debt, less growth approach is now being signalled.

As China's economic growth slows, problems from its past dynamic growth have started to surface. The financial sector is most concerned about China's rising debt, which increased from some 150 per cent of gross domestic product (GDP) in 2008 to 250 per cent today.

China's current debt-to-GDP ratio is certainly very high, but not the world's highest. It is about the same as that for the United States, the United Kingdom and European Union, though much lower than Japan's. The composition of China's debt is also different from the debt pattern of other developed economies. In particular, its levels of household debt and public/government debt, both at about 40 per cent of GDP, are still relatively low by international standards.

China's household debt is low because of the Chinese people's high saving rate and also their general reluctance to take out huge loans for buying houses or consumer durables. Its relatively low public debt is the outcome of the central government's efforts to maintain fiscal balance, though with many loopholes at the local government level.

In all, the bulk of China's debt ends up mainly as corporate debt, now standing at 165 per cent of GDP. A lot of corporate debt is incurred by ailing state enterprises such as steel and coal, plagued by overproduction and excess capacity.

As in Japan, most of China's debt is largely domestic liabilities (borrowing among themselves) and its external debt, mostly short term, is about 10 per cent of GDP. This is very low by international standards.

Put China's total foreign debt in the context of China's huge US$3.4 trillion (S$4.6 trillion) of foreign reserves, by far the world's largest holding, and any talk of a Thailand-style financial crisis like that which occurred in 1997 would immediately be ruled out.


Furthermore, China's domestic debt was mostly incurred for investment and business purposes, not for financing social consumption as in some European countries. Taking into account its exceptionally high domestic savings - 48 per cent of GDP in 2015 - and the fact that most creditors and debtors are basically state or semi-state entities, the question of China's debt blowing up as another 2008 Wall Street meltdown is also most unlikely.

Still, the way by which debt in China had built up so rapidly in just a few years (with loans increasing at two to three times GDP growth) is still highly worrisome to financial circles. The risk of default is inevitably mounting, now that the economy has lost its high growth momentum. Even if such a high level of debt would not spark an open financial crisis, it could still hamper the normal functioning of China's financial market and slow its economic reforms.

In fact, as the major growth drivers from fixed investment to exports have substantially weakened, many indebted enterprises have been making heavy losses. Sooner or later, some of these debt-ridden state enterprises will have to face the final reckoning of painful debt restructuring. This, in turn, will lead to large write-downs of their assets, while for creditors, it would mean a wave of credit losses and debt write-offs.

Beyond the enterprise level, the burning issue is how such a huge debt overhang would operate as a serious drag on China's future economic growth. The government's policy measures to defuse the debt crisis - technically, "deleveraging" - often create the same macroeconomic environment that ends up cooling economic activities and squeezing further economic growth. In short, policies to deal with a debt crisis often involve a negative trade-off of lower economic growth.


Why is China's economic growth so debt-prone? Its economic growth was invariably accompanied by rapid expansion of credit and loans - currently at about 200 per cent of GDP. This is actually a deep-rooted problem for China, tracing its origins to its early days of central planning and evolving as part and parcel of China's transition to a market economy.

Under central planning, all state enterprises received their working capital directly from the state's budget appropriation. With market reform, they had to depend on loans from state banks for working capital. This led to an informal credit system, which was loosely regulated from the start.

Thus, whenever the government tightened credit, many enterprises under the credit crunch would be immediately caught in a "debt chain" and refuse to fulfil their payment obligations to each other. This had been a recurrent phenomenon through most of the 1980s and the 90s.

In the early 2000s, China was struck by a big banking crisis, with state banks incurring huge non-performing loans (NPLs) at over 30 per cent. Eventually, then Premier Zhu Rongji had to save the banking system by transferring the NPLs to newly set-up asset management corporations (AMCs), and then recapitalising the banks with state funds.

The present debt crisis was the outcome of then Premier Wen Jiabao's huge stimulus package of four trillion yuan, which was hastily put up to pump-prime China's economy in the wake of the 2008 global financial crisis. This led to excessive credit expansion - officially called "total social financing" - which, among other problems, led to explosive growth of local government debt and also rapid expansion of banks' off-balance sheets, commonly known as "shadow banking".

Compared with previous debt crises, the present one is thus much larger in scale and more complex in that it involved many new financial products and more financial institutions.

For a more fundamental long-term solution of its debt problem, China needs to break its "symbiotic" relationship, not just between debt and economic growth, but also the unwarranted and uncontrolled credit links between state banks and loss-making state-owned enterprises (SOEs). The former involves more thoroughgoing financial sector reform, while the latter, deepening SOE reform. Both reforms are actually inter-related.


Clearly, one of China's greatest policy challenges today is how to recharge its decelerating economy to maintain reasonably stable growth while effectively tackling its serious debt problem. However, policy measures to promote growth often run against the very objective of dealing with the debt problem. It is a hard choice. After some policy flip-flops, the Chinese leadership has finally come to accept this.

China's high growth came to an end in 2013. However, the government was initially reluctant to accept such a reality as it had kept on using proactive monetary and fiscal policy to prop up growth.

It was not until December last year that the government started to push for "supply-side reforms", along with deleveraging. This came about after the government realised that its large demand-side stimulus package, of six rounds of interest cuts plus four rounds of reducing the banks' reserve ratio in 2015, had failed to turn the economy around.

Still, as downward pressures continued to mount during the first few months of this year, Premier Li Keqiang was under pressure to support growth by again resorting to demand-side stimulus. In the event, China's growth in the first quarter of 2016 was stabilised at 6.7 per cent. But this turned out to be a hard-earned growth based on a huge injection of credit and loans - that is, clearly at odds with the deleveraging policy.

The watershed in China's macro- economic management policy came on May 6 this year with President Xi Jinping publicly enunciating his policy preferences in a front-page article in the People's Daily under an anonymous "Authoritative Figure" byline. In brief, he declared that any excessive demand stimulus, in artificially propping up growth, would also push up debt. Such a debt-fuelled growth was unsustainable. He thereby described China's future growth path to be in L-shaped pattern, not the V-shape or W-shape of the past.

This implies that China's future growth will gradually and slowly decelerate, with no more spurts of higher growth to be generated by artificial stimulus.

Mr Xi then made clear his policy preferences for stepping up supply- side reforms, which would include reducing debt, cutting over- production and overcapacity, and liquidating some ailing "zombie" SOEs. This amounts to an official endorsement of moderately lower economic growth as a trade-off for an acceptable rise of debt.

Translated into policy reality, the government is satisfied with its present range of economic growth at 6.5-6.7 per cent, which is strong enough to take care of employment and other social needs while facilitating structural reforms.

To tackle the debt issue, the government has already started a debt-for-equity swap scheme to securitise bad debt, and also shows greater determination to shut down or merge "zombie" SOEs. Progress has been made, but with still mixed results.

A lot of China's bad debt, particularly at the local government level, has been the result of years of mismanagement, corruption and rent-seeking activities of officials in charge. For this kind of bad debt, the government will eventually have to "socialise" it by writing it off.

The writer is a professorial fellow at the East Asian Institute, National University of Singapore.

A version of this article appeared in the print edition of The Straits Times on September 10, 2016, with the headline 'China's great policy dilemma: More growth or less debt'. Print Edition | Subscribe