Is China's credit bubble really a problem?
Is China's credit bubble really a problem?
Bubble? More like Instant Pot
The credit “bubble” is an issue that needs to be dealt with but I think it can also be blown out of proportion (no pun intended).
As with most things in China, if you dig a few layers deeper into the topic, you will find that it is a lot more nuanced than the simple narratives you often see in the headlines.
Three Big Ideas
Why can too much credit or debt be a problem in the first place? Allow me to explain with three important ideas.
Idea #1: Debt is only as good as the underlying economic activity that it funds.
All debt is not created equal. How we determine the quality of debt — from the perspective of its contribution to economic growth — is by looking at the underlying activity that it is financing. If you have a great idea for a project, build it efficiently and quickly ramp up utilization of the finished asset, then the debt you incur on the project is highly likely to be “good” in that it will most likely be paid off under the original terms of the deal. Debt is “good” to the extent that the underlying economic activity that it finances makes sense.
And with bad projects, there can also be a varying degrees of “bad” — there is a significant difference between the entire debt being written down to zero and debt that is say 80% recoverable. “Credit quality” is everything.
Idea #2: The more debt there is, the more vulnerable an economy is to economic volatility and shocks.
Even if the underlying economic activity funded by debt is generally okay, the more heavily indebted you are, the more vulnerable you are to swings or volatility. No one person or regulator — no, not even the CCP — can control every variable in a small economy, let alone one as large as China’s.
This concept can be illustrated by simple math:
If you build a house for $100,000 and funded it with $50,000 of debt (50% loan-to-value or LTV ratio), then your equity is worth $50,000. If the value of the house declines by 5% ($5,000) and you are forced to sell, you will realize a loss of 10%. But if you had funded it with $90,000 of debt (90% LTV), then you will realize a loss of 50%. Further, in such a scenario, you are much more likely to be a forced seller.
A corollary to this idea is that the more complex the structure of your debt, the harder it is to control (and thus the more vulnerable the economy is to debt). Foreign-denominated debt also raises the fragility of a financial system because it is harder to control (fluctuating exchange rates, usually foreign/offshore investors).
At some point things will go wrong. The more conservative your financial system (measured in terms of both amount of credit as well as complexity of said credit), the more easily you will be able to handle shocks whether they are internal or external in origin.
Idea #3: There are varying degrees of economic damage caused by credit crises. A big factor in the severity of the damage depends on the lead time you have to absorb and deal with the underlying losses.
The worst crises are the ones where regulators and other market participants have little time to adjust to an economic shock. In times of panic, decision-making is generally not as rational and intelligent.
The most recent example of a particularly acute crisis was the Global Financial Crisis of 2008–2009. As the market started to realize the significant level of malinvestment in real estate and further that this problem had been magnified by creative financial engineering — panic started to build ultimately resulting in the collapse of Lehman Brothers in a shockingly rapid timetable.
At that point, the global economy was in full-on panic mode: banks cut lines of credit, capex plans were cut, companies went bankrupt or announced mass layoffs and regulators had no choice but to throw a massive amount of money at the problem lest it get even worse. There was a high degree of real-world costs of financial distress in this one as society had to adjust to massive disruption, heightened anxiety and emotional distress.
If there had been more time to absorb the losses, some of the more acute pain could have been avoided.
The China “Credit Bubble” Narrative
In a nutshell, the China “Credit Bubble” narrative is as follows:
In the wake of the Global Financial Crisis which resulted in a huge shock to its export sector (which accounted for close to a tenth of its GDP), China instituted a massive domestic stimulus plan.
This led to a surge in domestic investment that was largely funded by the state-controlled banking system.
While GDP growth remained relatively high — it was of “low quality”. The theory was that pushing through that many projects through the pipe at once is too much for an economy to handle — the ol’ “drinking water from a fire hose” metaphor.
This resulted in massive waste, corruption and inefficiency. “Ghost cities”, “glitzy” but unnecessary high-speed rail projects, under-utilized factories and empty apartment buildings were cited as hallmarks of this low-quality economic activity. Once the stimulus ended, GDP growth would fall off a cliff.
Meanwhile, China’s debt to GDP ratio was rising rapidly. By the end of 2017, China’s “total social financing” had increased to over 200% of GDP, up from less than 140% prior to the Global Financial Crisis. More “aggressive” views on China’s “real” debt-to-GDP surmised that it was really over 300%.
Since GDP is supposed to stagnate (or even collapse, according to some), eventually the credit “bubble” will pop and China will have to face a day of reckoning in the form of a financial crisis.
We Might Need to Use a Different Metaphor
I have several issues with the China “Credit Bubble” narrative that all tie back to the three “Big Ideas” I described above.
(1) To me, the most critical question is really around the underlying asset performance, not the debt-to-GDP level.
Those who support the “credit bubble” narrative tend to focus almost entirely on the amount of debt. When it comes to asset quality, they tend to just make the blanket assumption that the underlying economic activity that was funded/stimulated was poor.
It is easy to find a bad project, especially when you are specifically looking for it to confirm an existing worldview. “Hey look at that empty apartment building!” “See, that train line is losing money! Told ya’ so. #centralplanning” Similarly, it’s easy to find “experts” to provide the right quote that supports any narrative.
But China is a big place. What matters is the aggregate level of malinvestment in the system — the good blended with the bad — and that is a lot harder to figure out. But it’s really the most important piece of the equation.
But most analysts out there don’t appear to be trying to figure out how the underlying assets are performing. Maybe part of the reason is because it is not an easy task. China is big and the data is not always available or easy to parse. The data available to calculate debt is more standardized and easier to crunch. But if you are really trying to answer this question, you have got to take a dispassionate view on the assets and form your own rational judgments.
For example, I have recently been studying China’s high-speed rail industry — where there is actually quite a bit of financial data to examine if you know where to look — and I was surprised at some of the underlying economics and financial metrics that I came across: How profitable is China’s high-speed rail?
I do not have the complete answer here either, all I know is that it is foolhardy to conclude that it is “inevitable” for the “credit bubble” to pop without having done the proper analysis on the underlying assets.
(2) Second, there is a fairly wide range of views on how to calculate the debt-to-GDP ratio itself.
As mentioned above, some calculate debt-to-GDP at a little over 200% while others have estimates as high as 300% plus.
This is relevant because China’s debt-to-GDP ratio is then compared with other countries to try to benchmark whether it is low or high on a relative basis. Depending on how you define the numerator, China can come out looking really stretched or in line with others.
Another thing that many do not fully appreciate is how some of the increase in China’s debt-to-GDP ratio is not the result of new credit creation (over-investing), but merely increasing sophistication of the financial system via “shadow banking” products like entrusted loans and wealth management products (“WMPs”). These new “shadow banking” products sometimes leads to double-counting of the numerator (total debt) when you are comparing the change in debt/GDP over time. I explain in more detail in a blog post I wrote earlier this year.
Most advocates of the “credit bubble” narrative view “shadow banking” as a net negative and risk, merely another way for China’s economy to over-invest in unnecessary projects. After all, the term “shadow banking” does sound quite ominous and threatening — and it doesn’t help that the acronym WMP looks so similar to WMD (“weapons of mass destruction”) in the English translation! The original Chinese version (理财产品) sounds a lot less threatening.
However, what many do not fully appreciate is how “shadow banking” products are actually helping funnel credit to the “good” parts of the Chinese economy: private enterprises that have historically been starved of debt financing because they were generally unable to get loans from state-owned banks. As I write in the aforementioned blog post:
The much-maligned “shadow banking” sector itself has really been a way to provide alternative financing options for China’s private enterprises.
Historically, access to bank loans has been very difficult for non-SOEs (state-owned enterprises) so China’s private enterprises had to rely largely on equity which is the most expensive form of financing.
Through “shadow banking” products like WMPs and entrusted loans, China’s much more productive and efficient private sector now has greater access to a variety of financing mechanisms.
This is a positive development and the explosive growth in “shadow banking” products is a sign of how much pent-up demand there had been for less-expensive financing sources.
Lastly, while the structure of China’s debt is definitely getting relatively more complex compared to before with the new “shadow banking” products, it is still pretty simple compared to more developed countries and their more mature financial systems. One way to measure the level of complexity is by counting the number of “credit intermediation” steps between the lender and borrower. According to the BIS report referenced above, the average number for China is two to three compared to seven in the United States.
(3) Third, tight control that Chinese policymakers have over the financial system can mitigate the severity of a potential credit-induced financial crisis.
This is something that is widely recognized by most analysts (although the emotional response can range from admiration to disgust depending on your perspective) so I won’t get too much into the details here.
The key point is that even if there is a tremendous amount of malinvestment embedded in the economy, the probability that it “pops” or “explodes” (like a bubble typically does) is very low. Instead, malinvestment is far more likely to be absorbed over a long period of time, more akin to the automated cooldown cycle of one of those newfangled pressure cookers (which are awesome, by the way).
Knowing this, we ought to really consider changing the metaphor that we use to think about China’s credit situation from this …
… to something that looks more like this …
