It is no secret that China’s credit bubble is the largest in the world today, and one which poses the greatest systemic risk to global financial stability. With the quinquennial Chinese Communist Party congress concluded and the veneer of stability no longer required, it is an opportune time to consider how China’s credit growth might be the source of instability. Victor Shih of the Mercator Institute for China Studies recently published a report outlining the current state of China’s credit bubble, and lays out several scenarios in which China’s excessive leverage could lead to a financial crisis.
Shih estimates that China’s on-balance sheet credit and shadow banking assets reached a staggering 329% of GDP as of May 2017, more than 80 points higher than the IMF’s estimate of 242% of GDP in 2016. Shih also estimates that China’s credit-to-GDP ratio increased 34 points in the 17 months to May 2017, or roughly 52 trillion RMB. As the following chart from the IMF shows, rapid accumulation of credit and the associated debt service burden tends to lead to financial crises, and China’s credit growth is well above historically-observed credit booms.
China’s indebtedness is such that since 2012, annual interest payments have exceeded the incremental increase in nominal GDP. This means China either needs new credit to service interest payments on existing credit, or must devote a rising share of GDP to service interest, which effectively acts as a tax on growth. Shih writes: “China as a whole is a Ponzi unit. Total interest payments from June of 2016 to June of 2017 exceeded incremental increase in nominal GDP by roughly 8 trillion RMB. Since we did not see large-scale defaults in China, the new additional interest burden must have been financed in some way. Most likely, roughly this amount or more was capitalised as new loans, contributing to the rapid rise in total debt.”
As with any analysis of China, it must be remembered that the Chinese Communist Party tightly controls almost every aspect of the Chinese economy and financial system, which may allow its leaders to mitigate or even prevent a crisis through methods unavailable to other countries. Having said that, here are Shih’s four scenarios of financial crisis in China:
- Household sector crash, like what happened in the US during the GFC. This scenario is unlikely to cause a financial crisis on its own, as Chinese household debt of 41 trillion RMB as at June 2017 is less than 60% of GDP, compared to over 90% in the US pre-GFC. Furthermore, household debt is less than 20% of total bank assets and is expected to remain around that level over the next several years as both household debt and bank balance sheets grow.
- Panic in the shadow banking sector, which has rapidly expanded to 50 trillion RMB of assets, or 65% of GDP. Despite regular warnings in the financial press about the dangers of wealth management products and trust products, Shih does not believe shadow banking is a systemic risk to the financial system, so long as the central bank and commercial banks continue to support shadow banking with interbank loans. The biggest risk Shih sees to the shadow banking sector is if central bank liquidity dries up and/or regulators crack down too sharply on banks’ exposure to non-bank financial institutions.
- Capital flight and dwindling foreign exchange reserves. Between mid-2014 and early 2017, China’s FX reserves fell by US$1 trillion, with peak monthly outflows of US$100 billion in late 2015. Capital controls implemented in 2016 and 2017 have reversed the decline in FX reserves, but China remains vulnerable to further capital flight. As the chart below shows, China’s FX reserves have fallen from 20% of M2 money supply at the end of 2014 to just over 10% of M2 in July 2017. This means if households and corporates moved just 10% of money supply offshore, China’s FX reserves would be depleted.
As China’s credit bubble continues to inflate, money supply will increase alongside, the outflow of which would put further pressure on the FX reserves. A rapid depletion of China’s FX reserves could force a “maxi-devaluation” of the RMB, which could trigger severe inflation, high interest rates and substantial asset depreciation. Overleveraged households and corporates would see the value of their physical and financial assets fall even as their debt service obligations rise.
4. Withdrawal of credit by international lenders, especially if this coincides with another bout of capital flight. One of the arguments for China’s credit bubble not being a systemic risk to the global financial system (and domestically, even) is that the vast majority of Chinese credit is denominated in RMB, and the central bank can print more RMB to mitigate a domestic financial crisis. However, the PBOC cannot print foreign currencies, and is thus powerless to stop an external panic without sacrificing its FX reserves. Shih estimates Chinese external debt at US$1.9 trillion, of which US$1 trillion is short-term interbank borrowing that can evaporate quickly. Part of this external debt has also been used to meet USD outflows from China, which may have helped to keep a floor on China’s FX reserves.
Shih writes: “If foreign creditors one day discovered the precarious nature of their loans to Hong Kong or China-domiciled companies, or if an interest rate spike in the United States caused a reversal of the flow of funds to emerging markets, Chinese and Hong Kong banks may suddenly find themselves unable to roll over the massive amount of liability to foreign banks…For a Chinese government obsessed with control, defaulting on global obligations is much preferred over the uncertainty of running out of reserves.”
If China defaults on its external creditors, it would be cut off from foreign funding and its FX reserves would be run down in a vicious cycle as foreign investors and domestic households and corporates rush to move their financial assets offshore. In this scenario, it may take a maxi-devaluation of the RMB and surging domestic interest rates to preserve China’s FX reserves (again, the Communist Party has more monetary and policy levers to pull than most other countries). Such drastic measures could result in mounting domestic defaults, bankruptcies and a significant slowdown to China’s growth.