China's Debt Crisis: A Threat to Chinese Dream?

In September 2016, Bank for International Settlements (BIS) released its quarterly review which stated that China’s credit-to-GDP ratio hit 30.1 in the first quarter of 2016. Last year, BIS quarterly review reported the figure for China at 25.4 level.[1] Credit-to-GDP ratio is a measure which looks at debt to GDP ratio and compares it with economic long term trend. According to BIS, when a country has a measure of about 10 on its credit-to-GDP ratio, it is at a high risk of banking crisis over the next three years and thus the current figure for China is three times bigger than the danger level. How could China reach this potentially damaging point? Moreover, what will happen next?

How China ended up this way

            The explanation of how China could reach this point could be likened to the explanation of why we order so much food when we go out in extremely hungry condition. As soon as we arrive in the restaurant and take a look at the menu, everything turns into something highly tempting. Due to the fact that our bodies need food, and urged by hunger, we order almost everything to eat. In China’s story, industries take place as us, the hungry person, and banks are the restaurant, who supplies food for us.

            Back in 2008 when the global financial crisis hit the world’s economy, the government of China announced a RMB 4 trillion stimulus package to support industries in tackling the negative effects of the crisis. The stimulus has driven the Chinese economy to be outstanding after the 2008 economic downfall, with growth in 2010 reached a double-digits figure of 10,63%.[2] The way the Chinese government done this was by increasing the investment rate while the net export of China was being oppressed by the crisis.

            Stimulating industries with loans have caused the China’s debt to accumulate. According to an estimate by The Economist, China has experienced a dramatic rise in debt from 155% of GDP in 2008 to 260% at the end of 2015.[3] Although the increase in debt levels can stimulate the economy, China is also suffering from decline in its debt efficiency. China needs more and more borrowing to generate less and less economic growth; it initially took one yuan to generate one yuan of additional GDP, but it takes almost four yuan today.

Another part of the problem is China’s high amount of debt accumulation is also followed by an increase in the amount of bad debt. Bad debt is debt that is not collectible and therefore worthless to the creditor.[4] The ongoing accumulation bad debt is putting the country’s economy at risk as bad debts may cause banks to default and thus triggering a systemic problem to the banking sector.

Problem loans in China have doubled and are already 5.5% of banks’ total lending in the first quarter of 2016 due to the decline in private sector profitability.[5] The economic slowdown is one of the factors of this problem as it caused a decrease in export sectors, making it harder for corporations to pay back their loans. The second factor that contributes to the increase in China’s bad debt accumulation is because credits were invested in unproductive sectors. Just like human bodies who have capacity over how much food to eat, China’s economy has its own capacity over how much should be invested. Unfortunately, it looks like China has been investing things too much than it knows what to do with. China’s investment has been significant, but it looks like it takes a longer time for these investments to be absorbed. An example of this is the real estate sector. China had been stimulating investment on the sector, causing real estates to boom very quickly without being followed by proportional consumption rate. According to the Chinese government, China currently has two billion square meters of unoccupied residential space – that’s amount that can be used to host approximately 100 million people.[6] With such unprofitable condition, with supplies exceed the existing demand, real estates will not be able to pay back the money it had borrowed from the banks. This is the point where bad debts happen and the more it occurs, the more it will become a problem to the economy.

Is It Real?

It is also worth knowing that not everyone believe that China will likely experience the same debt crisis that has knocked down American and Japanese economy in 2008 & 1991. There are also some economists who are optimistic and saying that Chinese debt crisis is overblown by the media. They support the idea that Chinese economy will embrace a bright future in spite of its high debt in compared to its GDP. Those who are optimistic usually relies on the reason of China's government power over the country. The Central Government of China does have both financial power and political will to step in if anything bad happens by bailing out the banking sector if it is necessary. China’s banking system is also relatively well protected because it is largely owned and controlled by the state.

However, the arguments of those who are pessimistic can’t also be considered negligible. In May 2016, ABC News had reported that Chinese banks were sitting on the risk of RMB 8 trillion (approx.. 15000 trillion IDR) losses and fifty percent of banks’ capital base was at risk.[7] If the risk materializes quickly, banks will not be able to pay back the amount of money of its depositors, causing the banks to fail. Since banks are highly connected to each other, this can lead to a potential systemic crisis. Systemic crisis is a situation when a country’s corporate and financial sectors experience a large number of defaults and financial institutions & corporations face great difficulties repaying contract on time.[8] This can later affect the economy as banks and financial sector institutions are playing an influential important role to the wealth of the country and will surely be a knock down to China’s economy.

So What’s Coming Up After This?

            The answer heavily relies on how the government of China will address its economy. Crisis will likely get closer to happen if the government do nothing over what is going on today. But Beijing has previously said that it intends to move the debt fueled recovery model, though there should be a real action to prove this rhetoric.

            One of the ways that China can do is to make a shift upon its economical growth basis from investment to consumption. The key of the problem here is that China has been relying its economic growth on investment which is now turning to be unsustainable and exceeding the capacity. What China needs are better, and actually less, investment and more consumption-led growth models. Progress has actually been made, but it was still limited. Investment percentage from GDP has slightly fallen from 47% in 2011 to 46% in 2014. However, China has a long way to go since household consumption is still below 40%.[9] Moreover, there is a limit over how fast a country can shift its growth source basis. It is not easy to shift real resources among sectors. For example, if China decides to lower down its construction industry, it will take time for China to divert construction workers into other sectors.

            China can also take any monetary policy to curb down the credit boom. One of the ways is to control financial repression, a term that refers to the concept of setting savers return under the inflation rate to enable banks to provide cheap loans to companies and governments. Financial repression has attributed to China’s economic growth for financing its investment. It has also dampened consumer spending since smaller return makes it harder for people to spend more, making the share of household expenditure accounts smaller to the GDP. Avoiding financial repression will enable China to curb down its credit boom, control the level of investment, and stimulate more consumer spending to increase household expenditures share of GDP.

            One thing is for sure, the longer China delays to take action regarding this, the more severe the potential consequences will be.

oleh: Anas Izzuddin | Ilmu Ekonomi 2016 | Trainee Divisi Kajian Kanopi 2016

Footnotes :

• http://www.bbc.com/news/business-37403363
• http://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG
• http://www.economist.com/news/special-report/21697983-china-needs-free-up-its-financial-system-even-if-it-hurts-says-simon-rabinovitch-big
• http://www.investopedia.com/terms/b/baddebt.asp
• http://www.economist.com/news/leaders/21698240-it-question-when-not-if-real-trouble-will-hit-china-coming-debt-bust
• http://www.aljazeera.com/programmes/countingthecost/2016/09/china-debt-160924081946832.html
• http://mobile.abc.net.au/news/2016-05-24/chinese-banks-1.7-trillion-debt-time-bomb/7439844
• http://www.worldbank.org/en/publication/gfdr/background/banking-crisis
• https://www.project-syndicate.org/commentary/china-leaders-debt-dilemma-by-adair-turner-2015-11

Related Sources :

• http://www.bbc.com/news/business-37404838
• https://www.youtube.com/watch?v=KJoRTTciPf0&list=PLd25R7cp2PcfuccRDPgbqXBvBD9Xjvi9R&index=2
• http://democracyjournal.org/magazine/36/the-coming-china-crisis/
• https://www.youtube.com/watch?v=gCzZEth8uNA&index=3&list=PLd25R7cp2PcfuccRDPgbqXBvBD9Xjvi9R
• https://www.youtube.com/watch?v=7enlEd_1XP4&index=4&list=PLd25R7cp2PcfuccRDPgbqXBvBD9Xjvi9R