China’s total debt quadrupled between 2007 and 2014, which was about one-third of the $57 trillion in debt added globally during that period. Can this possibly be safe?
To answer this question, the McKinsey Global Institute devotes an entire chapter to China’s debt in the new report Debt and (not much) deleveraging. The key issue is whether China can slow the growth of debt without unduly crimping GDP growth, which already has fallen to the lowest rate in nearly a quarter century (see my Jan. 27 post here).
Our conclusion is that China’s debt situation warrants careful monitoring. In broad terms, China’s debt has moved from a developing economy level (158 percent of GDP in 2007) to advanced-economy status (282 percent in 2014, a bit higher than the United States and Germany). Not only does the speed of this debt buildup raise alarms, so does its composition. Almost half of new debt is flowing into the property sector and related industries, and around 30 percent of debt is provided by a shadow banking industry, whose lending standards and exposures are not easily discerned.
That’s not ideal but it may be manageable. Household and government debt are both low, even by the standards of developing economies, while debt of non-financial corporations is high. China has the financial wherewithal to weather a debt-induced crisis. And China’s government is taking steps to reduce the risk of crisis.
The report focuses on three areas of potential risk: a concentration of debt in the property sector; reliance on shadow banking; and the large debts of local governments.
- Real estate. Nearly half the new debt in China since 2007 has gone to real estate development or related industries such as steel and cement. Now, the property sector is cooling off. The value of residential real estate transactions in 40 Chinese cities, after rising 26 percent per year for 10 years, fell by 14 percent from April 2013 to August 2014—and by more than 30 percent in Beijing and Shenzhen. While Chinese households are not, in general, over-extended with mortgage debt, a deep and prolonged housing slump could have huge impact on the construction sector, which accounts for 15 percent of GDP and includes tens of thousands of small players who would not be able to meet their debt obligations. The steel and cement industries, which already have excess capacity, would also suffer.
- Shadow banking. The so-called shadow banking system—consisting of unregulated non-bank lenders—accounts for 30 percent of all new credit since 2007. Shadow banks, such as trust companies, raise money from wealthy investors seeking high returns and lend to players in real estate as well as to companies that cannot qualify for bank loans. Not only is shadow banking concentrated in real estate, the quality of its underwriting is not known—nor is the total exposure of shadow banks. One trust company missed its payment to investors because a single borrower—a steel company—missed a payment.
- Local governments. As a result of China’s rapid urbanization and limitations on how local governments can raise revenue, the debt of local government in China has grown to more than $2.8 trillion. About $1.7 trillion of this is owed by local government financing vehicles, off-balance sheet entities that are used to fund investments in infrastructure, social housing, and other types of construction. The ability of some local governments to pay back their debts is in question: a 2014 audit found that more than 20 percent of recent loans were used to pay older debts and that almost 40 percent of debt servicing and repayments were funded by land sales.
Chinese policy makers are certainly aware of the risks associated with unsustainable debt and are taking steps to reduce them. The government has imposed punitive interest rates for mortgages on second homes, and banned purchases of third homes to cool off the real estate market . (However, facing slower growth, the central bank cut interest rates last fall—illustrating the tension between growth and safety). In shadow banking, the government has imposed stricter product marketing rules on trust companies. To reduce reliance on land sales and LGFVs, the government has allowed cities to issue municipal bonds (on a limited basis). The state also has changed the incentives for local governments, emphasizing sustainable economic development, social harmony, and environmental protection, which takes pressure off cities to build more costly infrastructure. If these measures are sufficient—and are implemented consistently—China’s debt might remain merely a potential concern for the global economy.
Image: Jan / Flickr
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I’m a Director in McKinsey’s Shanghai office and Director of the McKinsey Global Institute (MGI) in Asia. I also co-lead the Urban China Initiative (UCI), a thinktank devoted to transforming China’s urban future. Visit the UCI website here.