Is China's Public Debt Worrisome? ; By Madhumitha R

Article: 16/2024

“I sincerely believe that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale.”

― Thomas Jefferson

Debt is a key feature of any economy, particularly a growing one. However, China’s debt has raised alarm within and outside the country. In this article, I attempt to understand China’s debt. The article presents a snapshot of these questions - how much debt is too much debt for China? What are they doing to alleviate the debt, and is it effective?

I) Interpreting Estimates of China’s Debt

Currently, China’s debt-to-GDP ratio is second only to the United States of America. China’s total debt-to-GDP ratio has increased rapidly through the years, standing at 280% of total GDP in 2023 (International Monetary Fund, 2023). The ratio was close to 70% in the 1980s, increasing fourfold over the years. From 2009, corporate non-financial debt rose dramatically, leading to a dramatic increase in debt. This increase has contributed to more than half of the rise in global debt between the periods of 2009-2022 (Global Debt Monitor, 2023). This sharp increase in China’s debt in the last few decades is owed significantly to the mounting non-financial corporate debt(1). According to the National Institute of Finance and Development, the total outstanding non-financial debt rose 13% from 2022 (NIFD, 2023). By 2023, China’s non-financial corporate sector debt amounted to the sum of its local and central government debts. Industries also contribute to the non-financial sector corporate debt - ferrous, non-ferrous metals, chemical and machinery are industries that contribute quite significantly.

There are three significant components in China’s total public debt - the central government debt, local government debt, and the debt of Local Government Financing Vehicles (LGFVs), which are the most significant driver of the non-financial sector corporate debt in China (Herrero, 2023). Lead Economist at Oxford Economics estimates that a staggering 4.7 trillion yuan of LGFV debt will mature this year (Lee, 2024). In itself, debt is not necessarily a major threat to healthy economies, but the numbers in China are staggering. With the slowing economy, risks of default and crises are high. The real numbers of total debt are elusive to us, but the International Monetary Fund estimates that of the government debt, 400-800 billion dollars is at high risk of default (Feng, Li, 2023).

For a central government, these numbers are not necessarily shocking by themselves. But the debt of provinces and cities present a herculean challenge for the Chinese economy. Both the explicit and hidden debts(2) of local governments swelled during the pandemic years(3), coming to a head in 2023 (Xie et al, 2023). In 2023, the debts of the local governments exceeded 120% of their incomes in the previous year, and two-thirds of the local governments were in danger of breaching the unofficial threshold guideline on debt set by Beijing (Xie et al, 2023). An analyst from the US Investment Advisory states that “Debt for the central government is a small issue, but for some local governments, it may take five years or more to resolve their debt issue (Toh, 2023).” According to William Lam, who is a senior fellow of the Jamestown Foundation, China’s total local government debt is close to 13.8 trillion USD (Toh, 2023).

In the debts of local governments, there are two major kinds - one, agency debt that is the funds directly borrowed by state government institutions like schools and hospitals; two, the debts of the Local Government Financing Vehicles (LGFVs). This high amount of LGFV debt is a feature of Chinese economic policy in the last two decades, and will pose a challenge for China. In order to promote fiscal discipline, China crafted some regulations on local government borrowing from banks. To circumvent this, local governments established the Local Government Financing Vehicles (LGFVs) after the 2008 financial crisis for the purpose of obtaining bank loans. In turn, banks could not prohibit this as they were owned and controlled by governments.

The risk of a local-government led debt is multifaceted: The total debt in China is a significant liquidity risk in the case of adverse events and shocks (IEF, 2023). There are a few possible outcomes. One, the local governments may default and create a full-fledged financial crisis in China. However, according to economists this is a more remote possibility. The continuous impact of this debt is that cities will have to for a long period of time cut their spending and delay investments, which could pose a significant threat for economic growth (Xie et al, 2023).

Debt is not a liability for economic growth alone. Laborers in technological companies, manual workers, teachers, and people on the lower end of the income ladder are bearing some brunt of the issue. Several of them report that they have been facing salary cuts, cuts to pension benefits, and pay hikes. Strained government finances have created a significant strain on government support to healthcare and protests have erupted in Wuhan, Dalian, and Guangzhou.

China’s debt problem has been long coming. The following section traces short-term, long-term, and structural factors that have contributed to China’s debt.

II) Causes of China’s Debt

i) Short-term Factors

There are several short term and long term causes for the colossal debt that China has accumulated today. The short term causes have plagued the Chinese economy in the last five years. First, the housing crisis. In China, local governments are heavily dependent on land deals for their income (Toh, 2023). The housing sector’s regular booms and busts are a result of the local governments’ attempts to expand the real estate markets, which then provide them a significant source of income (Huang, 2023). In the face of a debt crisis, each of the local governments may act in different ways. Some of the provinces may be protective(4), where they protect state sectors and the jobs remaining. Some others may push the private sector to make debt adjustments, leaving them choked for capital. The pandemic was another significant cause of distress in the short term, where local governments had to make significant expenditures and suffered economic losses.

ii) Long-term Factors

China’s response to the global financial crisis has significantly shaped the debt problem today. After the global financial crisis, China undertook active efforts to revitalize domestic demand, mostly through stimulus packages. To paint a picture of the scale of the stimulus package in 2009, it constituted 12% of China’s GDP (Horrero, 2023). The government at the time had one mandate - to boost investment and demand. China adopted a loose monetary policy to create a financial environment of relaxed lending, and local governments went on a borrowing spree. The period of 2009-2015 marked credit expansion of 150% (National Bureau of Statistics, 2023).

According to the Carnegie Endowment for International Peace, China’s debt problems today stem significantly from the 586 billion USD stimulus package that the government announced just after the crisis. In 2009 alone, the stimulus package(5) of 5 trillion RMB was pushed on to the Chinese economy, and local governments took on several infrastructure projects. Binge investments had two components in China - indebtedness and excess production capacity (IEF, 2024). Ironically, this stimulus package pushed local governments to borrow more money. China is a manufacturing company, and stimulus packages after the global crisis intended to amp up the infrastructure.

However, these are industries that reap the benefits of economies of scale. Provinces are competitive in China, seeking loans to scale up for profitability of their projects (Sridharan, Informal Communications, 2024). There are other reasons that the stimulus packages caused increased borrowing from local governments. Aravind Yelary, Professor at the Jawaharlal Nehru University told C3S, that around this time, provinces expected the economy and demand to grow at a higher rate, and this guided their borrowing. However, the growth rate and demand did not match expectations, leaving them with overcapacities and a pinch in their purse. This situation is exacerbated by the competition that is fostered between provinces in China. In this scenario, shadow banks were born (Verkhiver, 2017).

‘Shadow banking’ is a term that was coined by the United States (US) in 2007, and refers to lending and financial activities conducted by institutions not regulated as banks (Verkhivker, 2017). In China, institutions under the shadow banking sector range from microfinance companies, credit guarantee firms, and even small-time pawn brokers (Palmer, 2023). Some of the activities in the shadow banking sector are seen as legitimate finance, however, there is a gray area of financial transactions that occur without the knowledge or approval of the center. The shadow banking economy in China ranges in trillions of US dollars(6) (Cheng, 2023). Shadow banking seems to have a direct correlation with stimulus packages - in provinces that took out a significant number of stimulus related loans in 2009, the shadow banking sector grew significantly between 2012-2016. The bank debt from stimulus packages were due in 2012, which also coincided with the surge in shadow banking activities (Verkhivker, 2017).

LGFVs and shadow banking were essential during China’s phase of debt-fuelled growth. In many ways, it was this shadow banking sector that built China’s roads and railways, keeping the liabilities off the government’s bank sheets. Shadow banking is a problem because it does not come under the regulatory oversight of the government. Shadow banking represented 1/3rd of all loans in China from 2012-2016 and when the government placed a crackdown on the sector, the growth in China’s credit was cut in half (Verkhivker, 2017).

iii) Structural Factors

Both long term and short term factors that have created the debt problem in China today. However, the story goes back further than that. The structure of China’s economy over the years has led up to the debt that they face today. One key factor contributing to the current predicament is the rampant income distortions in China. Over the years, income has been transferred from the working class to the rich - that is, from high consumers to high savers. Currently, the income distortion in favor of savers has contributed significantly to the lull in economic demand. Due to rampant inequality, it defies the conventional economic logic that increased savings economy-wide will lead to increased investments due to rampant inequality. While savings spurred investments during the 1980s, businesses have not expanded their investments proportionate to the increased savings, since the 2000s (Herrero, Xia, 2014).

III) How Much Debt is Too Much Debt?

Debt is a central feature of any growing economy and often countries can sustain high levels of debt. However, beyond certain thresholds, debt can get worrying. In the following paragraphs, I attempt to understand if China’s debt is worrying, and what factors are specifically cause for concern. Several economists and global economic institutions have addressed the question of debt over time. The concept of ‘debt sustainability’ is used to explain how long the borrower can accumulate debt with the expectation that it will be able to continue to service it. Finally, all estimates of unsustainability of debt, that is, the point at which debt becomes unsustainable are probabilistic estimates (IMF, 2002). The debt-to-gdp ratio is one good measure to indicate the disparity between economic growth and debt levels. According to the World Bank, countries with debt-to-gdp ratios higher than 77% have faced economic slowdown over time (World Bank, 2024). Although low debt is not a guaranteed indicator of a healthy economy, typically, countries prefer lower values of debt-to-gdp ratios. However, in the case that this is exceeded, when does this become cause for concern?

According to economist Faria-e-Castro, three major factors influence the answer to this question - economic growth rate, strength of institutions, and the interest rates on debt (Hennerich, 2020). The post-pandemic situation of the Chinese economy is worrisome as per this metric. The previous paragraphs have established the precarious nature of the Chinese economy. Growth is stunted due to several economic crises post pandemic. The public health crisis, shut down of manufacturing, low demand, declining working population, and the real-estate crisis have contributed to the stunted growth.

In this case, the strength of economic institutions essentially depends on the freedom of the central bank in creating monetary policy. Essentially, not having a free and independent central bank wards off potential investors who are afraid of a default (Hennerich, 2020). Countries that have a high degree of central bank freedom are able to sustain higher levels of debt-to-gdp ratios. This also is tied to the third factor listed above, the rate of interest. Strong institutions in the countries allow lenders to lend money at lower interest rates which essentially brings down the cost of debt.

In China, although the central bank is supposed to be “relatively independent”, it comes under the central government (Wang, 2017). The question of independence for China’s central bank and other financial institutions is tricky - broadly, the central bank in China is not independent, conversely affecting their interest rate situation. By these measures, China’s debt does seem to be in the danger zone.

In the case of debt default, these are the following outcomes:

Source: Hennerich, 2020.

In China’s case, it appears that the second case is most likely. Particularly, since the economy is going through deflation, printing money might be an option that is considered. However, since the PBOC does not publish these figures, we do not know how much additional currency they may have already printed for recovery from deflation (Sridharan, 2024, Informal Communication).

However, China has made public other recovery measures that it plans to implement over the year. The following final section identifies these and discusses their motivations and effectiveness.

IV) Recovery Measures

China’s approach to solving the debt crisis seems slow so far. China has been taking some measures to combat its debt distress by embracing a more “supportive” fiscal policy (Cheng, 2023). For the first time since he assumed power, Xi Jinping made a visit to the People’s Bank of China (PBOC) in October 2023 (Cheng, 2023). However, only a few significant policies have been enacted to alleviate debt stress. In October, the government introduced a mechanism where local governments can issue special refinancing bonds which allows them to swap their debt. 24 provinces have issued 1 trillion RMB in refinancing mechanisms (Cheng, 2024). To prevent local government indebtedness for the future, China introduced a formal process through which the local government can borrow funds. The State Council, China’s top executive body, would determine the amount that local governments can borrow for each year.

Overall, it appears that Beijing is still downplaying the issue. Aravind Yelary, an Economist from the Jawaharlal Nehru University told C3S that China does not think of its debt as unsolvable or a major crisis (Yelary, Telephonic Interview, 2024). While the leadership is not acknowledging this as a mounting concern, since last year, the government has been rolling out measures to relieve debt distress. The People’s Bank of China issued the “ultra long” (7) special treasury bonds last month in 2024, to fund projects that align with national strategies (Tan, 2024). The announcement of these bonds is an important surprise, according to Goldman Sachs. It is still premature to say conclusively where the money from these bonds will go.

In terms of debt, the bonds contribute to the official government debt, but will not count towards the official fiscal debt (Lee, 2024). As measures of debt relief, it is still unclear how much of the proceeds from the bonds will go to the local governments. However, considering their precarious nature, it seems likely that a significant proportion of the proceeds will be allocated to the local governments. On the other hand, the “long” maturity periods of the bond, ranging from 50 years or so, indicates that there is no real pressure on the government to repay the loans soon. Sridharan Subramaniam tells C3S that if the central or provincial governments do not use the money effectively, this solution will not remedy debt, but just kick the can down the road (Sridharan Subramaniam, 2024, Informal Communication).

The head of the NDRC said that the funds will go towards supporting the following areas: scientific and technological innovation, integrated urban-rural development, coordinated regional development, food and energy security, and high-quality development of the population. These are industries that are poised to grow under the current Chinese policy. The premier also says that the public can expect more of these bonds to come in the coming years. However, other details about the bonds are still to be revealed. It remains unclear how and when the bonds will be sold, and when the bonds are dated to mature.

As a whole, it appears that local government and corporate debt are indeed China’s biggest woes, but in addressing debt, household debt is being overlooked. Addressing household debt could be a helpful step in correcting the debt ratio and encouraging spending.

Conclusion

Is China’s Debt Worrisome? Ultimately, by most economic standards, it is. Being a strongly centralized state, China has the potential to carry out swift policy measures, but as of now, the data is still scarce at every stage. Often, research on China carries significant speculation because of this lack of data. In this paper particularly, debt estimates, and their relief measures are clouded in uncertainty.

However, based on the relief measures rolled out so far, debt relief policy does not seem coherent enough. Thus, in the short term, the question of “who” should worry about China’s debt is more pressing, and tangibly manifest in Chinese society. China’s military budgets are only rising, and the budget cuts are coming at the expense of the working class. Whatever measures China takes in the future, it should ensure that it avoids a hard default, or extreme budget cuts in the social sector. All the steps taken need to be accompanied by ensuring that provinces utilize funds effectively.

Whether the government is officially worried or not, China has to reconfigure its economic path and ascertain how it intends to tackle its mounting debt, such that there are no major losers.

Footnotes:

Non-financial corporate debt refers to debt issued by non-financial entities in the form of treasury bills, commercial loans, and industrial loans.
The hidden debt refers to loans taken by local governments without the knowledge and/or official sanction of the central government at Beijing. It is a component of total debt.
China’s zero covid campaign ushered in billions of unplanned expenditure that went towards mass testing and lockdowns.
In this case, they are said to adopt a “fortress” mentality.
The director of the IMF thought that this was “good news for correcting imbalances.” The IMF recommended the same stimulus package method of economic recovery for the United States and the European Union, but they chose to use a quantitative easing Monetary Policy instead.
According to Foreign Policy, the sector was 3 trillion USD large in 2023.
These ‘ultra-long’ bonds have been issued only thrice in Chinese history - during the Asian Financial Crisis of 1998, the global financial crisis of 2007, and the pandemic. The uptake for these bonds will be pushed by the government - local people do not have several alternative investment routes, and companies will be urged to take up the bonds.