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Cracking the China ConundrumWhy Conventional Economic Wisdom is Often Wrong$

Yukon Huang

Print publication date: 2017

Print ISBN-13: 9780190630034

Published to Oxford Scholarship Online: July 2017

DOI: 10.1093/oso/9780190630034.001.0001

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China’s Debt Dilemma

China’s Debt Dilemma

(p.66) Chapter 5 China’s Debt Dilemma
Cracking the China Conundrum

Yukon Huang

Oxford University Press

Abstract and Keywords

China’s surging debt levels and an overheated property market have led many to believe that the country is headed for an economic collapse. Yet the argument that China is facing a financial crisis is overstated. China’s debt problem is largely confined to the state sector; its property market is not about to implode; and there is little evidence of widespread insolvency. The risks of shadow banking are also not as serious as many have argued. While the government has the discretionary resources to manage the situation, a set of SOEs does face serious financial problems and the country’s financing modalities are creating risks. Most observers see the banking system as the source of these problems, but the solution begins with reforming China’s fiscal system and restructuring management of SOEs. Addressing these issues would lead to a more financially sustainable growth path over the coming decade.

Keywords:   debt problem, overheated property market, shadow banking, fiscal reforms, restructuring SOEs, sustainable growth

In recent years, attention has shifted from concerns over China’s unbalanced growth and trade surpluses to anxiety about its rising debt levels and seemingly bottomless economic slowdown.1 Many among the financial community have warned that China is headed for an economic collapse with headlines such as this: “The coming debt bust—it is a question of when, not if, real trouble will hit China.”2

The argument typically begins by pointing out that China’s debt-to-GDP ratio has grown rapidly since 2009, about double the buildup that occurred in the United States before the GFC and in Korea before the AFC. Others compare China to Japan’s debt situation in the 1990s, that nation’s lost decade. As these uber-bears argue, such debt indicators have led to a financial crisis in all other cases—so why not in China?

The argument that China is about to fall off a financial cliff is overstated. China’s situation is different from the other crisis cases in many key aspects, the most important being that the debt problem in China is largely confined to the state sector whereas in the others it was largely between private agents. Comparisons with Japan’s lost decade are also misplaced since the kind of equity or property market collapse Japan experienced is highly unlikely in China. Nevertheless, China’s debt burden has been steadily increasing since the GFC and, if not stabilized within the next several years, will in due course dampen longer-term growth prospects. Thus the failure for the authorities to take more decisive steps so far is worrisome, even if warnings of an imminent crisis are overdone.

Although there are anecdotal but striking examples of financial stress in China, there is little evidence of widespread insolvency that could threaten the broader economy. But there are serious problems that need to be resolved among a narrower subset of construction and property-related firms, as well as others in the commodity and energy sectors dominated by stated-owned firms who often over spend since they can pass on any losses to the state. The risks of shadow banking, however, although warranting attention, are unlikely to destabilize the (p.67) system. In all but the most extreme scenarios, the government has the flexibility in the form of discretionary fiscal and financial resources to bail out the most important distressed entities and to recapitalize major banks. This will ensure that any tensions do not turn into the sort of systemic financial crisis that could derail the economy, as was the case elsewhere.

The stabilization process, however, will be messy and costly as the economy slowly hemorrhages financial resources and throws good money after bad to keep growth in line with official targets. China’s inexperienced new investor class also may react to market stresses in unexpected ways. Adjustments in an overbuilt property market will exacerbate vulnerabilities. And, the surge and then collapse of the equity market followed by a more recent surge in shadow-banking activity built on the issuance of weakly regulated wealth management products (WMPs) and lending between related firms have accentuated market perceptions about increasing risks.

These issues point to China’s need for reforms to slow the growth of bad debt and encourage productivity growth. While most observers see the crux of the problem emanating from banking vulnerabilities, its origins come from China’s weak fiscal system, which encourages local authorities to rely on bank loans including shadow-banking products for financing that should be coming from the government’s budget. The financial stresses are actually symptoms of underlying fiscal problems.3 In addition the moral hazard problem needs to be addressed. This means, for example, forcing SOEs to bear the full consequences of their borrowing decisions, including bankruptcies if necessary.

Enacting reforms and allowing for a period of subdued growth while the property market corrects could sustain medium-term growth of around 6 percent. This would keep China’s debt burden manageable. The alternative would be continued weakening of the economy, which—given the government’s considerable resources—would not manifest itself in a near-term collapse but would make it much more difficult for the leadership to reestablish a more sustainable growth path over the coming decade.

Understanding China’s Credit Boom

Why are the pessimists wrong in predicting an imminent collapse?4 In most countries that have experienced a financial crisis, the preceding credit surge has typically been the culmination of a long-term and broad-based deterioration in financial and fiscal indicators. China simply does not fit that pattern. It possesses a strong balance of payments position, modest fiscal deficits, and high household savings rates. Nor have the most vocal pessimists keyed in on the fact that (p.68) the dynamics of a debt crisis are different for financial systems in which the bulk of the debtors are SOEs borrowing directly or indirectly from state-owned commercial banks (SOCBs).

The country’s debt problems are rooted in the government’s November 2008 announcement of a 4 trillion yuan ($586 billion) stimulus package to counteract the effects of the GFC. Rather than being channeled through the government’s budget, the stimulus took the form of an explosion in bank lending, predominantly to SOEs and local governments.5

By 2010, the worst of the crisis seemed to be over—GDP growth rebounded to double-digit levels—and the government scaled back bank lending by about a third. But shadow banking—nonbank lending through entities other than government institutions and informal channels—classified as nonbank credit in Figure 5.1, quickly emerged to fill the gap, and by 2012, nonbank credit accounted for 40 percent of the new credit—more than double its share before the crisis.

The riskier elements of shadow banking in the form of loans from trusts and informal sources were reigned in after 2013, but in 2015, nonbank credit soared again. This was the result of the large volume of bonds issued by local authorities to reduce their bank debt levels and the smaller banks relying on WMPs to fund loans since they lacked the household deposit base of the major SOCBs.

China’s Debt Dilemma

Figure 5.1 China’s credit expansion.

Source: CEIC; UBS Investment Bank; author’s calculations

Altogether, the bank-credit stimulus and shadow-banking boom pushed China’s debt to over 250 percent of GDP—higher than most emerging market economies but lower than most high-income countries and about the same as the United States (see Figure 5.2).6 This intuitively seems about right, since (p.69) China is neither a developing nor a developed country. What has raised alarm bells, however, is that the speed of the increase in the period after the GFC was much higher than most other countries and by early 2017 some estimates indicate that the ratio is now over 270 percent. Only a handful of countries have experienced an increase in debt as a share of GDP of the same magnitude as China, and most of them—such as Greece and Ireland—experienced a financial crisis. Thus it seems reasonable to conclude that China will also suffer the same fate. But China is different in many critical aspects.

China’s Debt Dilemma

Figure 5.2 Debt Comparisons.

Source: Bank for International Settlements total credit statistics; World Bank World Development Indicators

Though credit booms can bring new risks, they can also bring beneficial financial deepening and economic growth. An IMF report explains that only a third of these booms result in a financial crisis.7 Further, countries that experienced credit booms between 1970 and 2010 saw 50 percent more growth in per-capita incomes over the same period than countries that experienced no credit booms.

What is more, while almost all financial crises are preceded by credit booms, China has none of the external vulnerabilities that often trigger a crisis, with a current account surplus of around 3 percent of GDP, external debt of only 10 percent of GDP, ample reserves in relation to external needs despite the recent decline, and a currency that is generally seen as appropriately valued.8 In contrast, crisis countries are typically running significant current account deficits of around 3–5 percent of GDP, burdened with a large share of external debt, and lacking flexibility because of minimal amounts of foreign reserves and low household savings rates.

Similarly, China’s banks are highly liquid and not particularly vulnerable to a US-style freeze of the interbank lending market. Loan-to-deposit ratios are not high, and the major banks are minimally dependent on large institutional accounts, drawing instead on a huge population of household savers. In short, (p.70) aside from some of the smaller regional banks, China’s banking sector is flush with deposits. Household debt has increased rapidly because of the rising share of mortgages, but it remains manageable relative to household incomes.

Corporate Debt

The clearest area of concern for China is corporate debt, and its size sets China apart from other countries. Over 80 percent of the rise in China’s debt-to-GDP ratio can be attributed to the explosive growth of corporate debt, which rose from 96 percent of GDP in 2007 to over 160 percent of GDP in 2016. It is much more menacing than household debt and now makes up 60 percent of China’s total debt. Even so, the risks associated with rising corporate debt in China are mitigated by the fact that much of it is concentrated in state-dominated sectors where government support is available. Moreover, industrial profitability, while declining, has remained broadly acceptable.

China’s large corporate debt share also reflects relatively underdeveloped equity markets and the exceptional role household savings play in the banking system. Consequently, firms—especially the larger state enterprises and local governments—find it much easier to borrow from commercial banks than to tap bond and equity markets for financing. This holds true even for investments with long gestation periods, such as infrastructure.

Although corporate leverage in China has risen significantly, it is not clear that it has reached crisis levels. Despite the sharp increase, China’s current level is still well below the median debt-to-equity ratios of the AFC countries in the year before the crisis.9

There is also little evidence that this overall rise in corporate leverage has led to widespread financial stress among firms. Wells Fargo analyzed the financial position of the industrial sector in 2013, which accounted for 60 percent of China’s corporate debt, and found little cause for alarm.10 Revenues have kept pace with debt accumulation in the industrial sector and, contrary to popular perceptions, interest expenses for most industrial firms as a share of revenues have not increased excessively.

An IMF study indicated that private firms had reduced their debt burden over time, but SOEs have increased their leverage.11 These firms are concentrated in real estate and construction as well as mining and utilities, largely from borrowing to increase capacity as part of the GFC stimulus program. There is a high degree of concentration of debt among these firms. For example, only sixty firms, mainly state owned, accounted for two-thirds of the liabilities in the real estate and construction sector among the two thousand firms surveyed.

(p.71) In a more recent study using data through the end of 2015, the research firm Gavekal estimates that the share of financially troubled and money-losing firms is around 10 percent, a ratio that is not unusual.12 This compares with 7–8 percent in 2011, so there has been some deterioration with the slowdown, but the comparable number was over 20 percent in 1998 during the AFC, which at that time necessitated massive layoffs. In sum, there is still no indication that debt servicing has become an unmanageable burden as a general issue, and while profit margins have declined recently, they are not distressingly low.

Still, there are prominent pockets of weakness. The steel, cement, coal, aluminum, sheet glass, and shipbuilding sectors are not as productive as other sectors, as capacity utilization rates have fallen sharply.13 Firms in these sectors account for 10 percent of industrial assets but only 2 percent of industrial profits, and their return on assets is less than half that of the industrial sector overall.14 Utilities and raw materials producers have also become highly leveraged, and the solar energy sector suffers from similar issues of excess capacity and falling, if not negative, profits. Overall, there is a significant impact on financial indicators but less of an impact on GDP growth because the valued added in many of these sectors (which make up GDP) is relatively less pronounced than in other activities.

These sectors’ struggles largely reflect the fact that they are dominated by SOEs, which are, as a class, highly leveraged and less commercially oriented. Given their weaker financials as a group and their dominance in high-risk sectors, it is likely that any financial stresses will be concentrated among SOEs and firms heavily involved in property development.

The debt-to-profit ratio of privately listed firms is 5 percent lower than in 2008, compared to a 33 percent rise for state-listed companies, with similar trends observed in other leverage ratios.15 The contrast between the financial position of private and state companies becomes even sharper when you consider their cash holdings. According to Goldman Sachs, private firms had sixty cents in operating cash flows for each dollar of current liabilities, while central government SOEs had just thirty cents.16 And as discussed later, SOE returns on assets have declined sharply over the past decade and are now only about half of that of private firms.17

These trends should not be surprising. In 2003, the newly installed Hu-Wen government put an end to the widespread privatization and shuttering of underperforming SOEs. This removed the threat of failure and left SOE managers with little reason to behave in a financially responsible manner. Any remaining incentives to behave prudently were eliminated by the postcrisis bank stimulus, when SOEs were charged with propping up growth.

Also providing a cushion for the SOEs—particularly the larger ones—is the fact that they are more likely to be bailed out, thus shifting the liability for their bad debts onto the government. While the government might consider allowing (p.72) some minor players to go bust as a means of disciplining financial markets, it is very unlikely that it will allow many major players to fail. Yet it is precisely the firms most likely to be bailed out that are most likely to mismanage themselves into requiring a bailout.

Some studies have shown that the larger firms have been increasing their net debt-to-earnings ratios in recent years, while smaller ones have actually deleveraged since the financial crisis.18 Even if the financial risks are not entirely concentrated in SOEs, much of the bad debt is likely to land on the government’s balance sheet in one way or another. The government has previously bailed out private firms that are seen as strategically important for localities.19

As in any emerging economy, there will be genuine defaults in the corporate sector that the government does not absorb. In the first half of 2016, defaults of a major SOE, Dongbei Steel, and a half dozen other companies shook the bond markets, causing prices to fall and new issues to be postponed.20 But studies have suggested that the actual numbers of bond defaults are likely to be only a couple percent of those coming due.21 Such defaults are not out of the ordinary for a large emerging economy in the midst of structural changes, especially given the need to reduce capacity in some sectors. They are unlikely to be significant enough to jeopardize the financial system. What is more, most of these defaults will be well anticipated—and well-anticipated defaults rarely cause crises. Any spillovers that occur are likely to be limited to other financially weak companies in similarly excess capacity sectors. That is not an entirely undesirable outcome, since China needs a process to weed out nonviable firms.

Local and Central Government Debt

Government debt, which is incurred predominantly at the local level, is not as high as corporate debt, nor has it grown as dramatically. For these and other reasons, central and local government debt is unlikely to prompt a financial crisis, but its complex and opaque structure may hide unpredictable risks. As pressure is applied to instill more discipline in local financing, there will also be a significant fiscal contraction with negative near-term growth consequences as evident in a prolonged economic slowdown.

The strength of the central government’s balance sheet on its own merits is uncontroversial: it had debt of just 29 percent of GDP in 2009, and it fell to around 25 percent at the end of 2014, according to IMF data. But this is an incomplete picture of the government’s financial health, because it does not account for China’s local governments, which take on the majority of the public debt while being implicitly guaranteed by the central government.

(p.73) Unfortunately, accounting for local debt is easier said than done. Local governments in China have been prohibited from officially running deficits or issuing debt since 1994. This has forced them to take a more circuitous route to finance their expenditures. In particular, local governments rely heavily on local government financing vehicles (LGFVs). These are SOEs set up by local governments to conduct activities that would normally be undertaken directly by the governments themselves, such as building roads and power plants.

Local governments support LGFVs with cash injections or state land transfers, which LGFVs then use as collateral to borrow from banks and capital markets. LGFVs invest that cash in projects to develop the local economy, particularly via infrastructure or new housing developments. The distinction between LGFVs and other local government SOEs is blurred and controversial, but even under the conservative official definition there are more than ten thousand LGFVs active in the country.

The borrowing of LGFVs through bank loans and bond issuance is relatively transparent and easily tracked through periodic financial disclosures by the LGFVs or the banks that lend to them. Local governments also borrow through the less transparent shadow-banking system. Such borrowing is not regularly disclosed and is difficult to track, forcing observers to rely on rough estimates and sporadic audits.

However, in December 2013, the government announced the results of the most comprehensive audit of local government debt to date, which indicated that shadow banks and other forms of nonbank financing grew from $360 billion at the time of the 2011 audit to almost $1.2 trillion in June 2013. The audit results indicate that the expansion in local government debt is predominantly occurring through shadow banking and other informal arrangements, since generally the local governments are not allowed to borrow from the formal banking system for investment needs. According to the audit, local government debt by June 2013 stood at just over 33 percent of GDP, up from 27 percent in 2010.

Adding the audit’s estimate of central government debt to the estimate of local government debt leaves China’s total public debt at about 60 percent of GDP in 2016, which is not alarming compared with other major economies. This is still much lower than most developed countries, in line with the generally recognized prudent ceiling of 60 percent, and lower than the other BRIC economies of India and Brazil.

Moreover, unlike other countries, China can directly access valuable assets should it actually run into debt-servicing problems. According to the Chinese Academy of Social Sciences, China’s foreign exchange reserves are roughly equal in size to China’s expected government debt.22 The government’s land holdings are also valuable, although the usage rights for much of the land have already been allocated. Finally, the combined assets of China’s 100,000 SOEs are worth (p.74) roughly $13 trillion according to the Ministry of Finance. After accounting for SOE debt, the net asset value of SOEs is $4.4 trillion, or roughly 50 percent of GDP.23 While it is true that many of these assets cannot be easily liquidated during a cash crunch, they can help finance a bailout over several years, and their mere existence can head off a sudden loss of confidence.

Local Government’s Fiscal Problems

Although the government is clearly solvent, LGFVs and the localities that support them do face short-term liquidity challenges. Much of the debt they have incurred is in the form of short-term loans from banks or borrowing through the shadow-banking system with short maturities. As a result, many are experiencing liquidity shortages. Most LGFVs are strong enough to cover interest payments, so debts are likely to be rolled over. Although such rollovers tie up banks’ working capital and prevent them from lending to more productive new projects, they represent a slow restructuring of local government debts rather than a crisis. In addition, nearly 4 trillion renminbi of bonds are being issued to replace some of the bank debt. With lower interest rates and longer maturities, this will also help moderate the servicing burden over time.

Beyond short-term liquidity challenges, there are at least three long-term vulnerabilities associated with local government debt: the misaligned fiscal system, incentives for local officials to overinvest, and the lack of transparency in local finances. Prior to the opening up of the economy in 1980, the government relied on the artificially protected profits of SOEs to pad its budget. When economic reforms were introduced, SOE profits plummeted and government’s revenues fell precipitously to around 10 percent of GDP until the major fiscal reform in 1994 which introduced new valued-added and consumption taxes.

The restructured fiscal system has steadily increased government revenue, which is currently around 22 percent of GDP, but it has also created an imbalance between the central and local governments. While the local governments were left responsible for funding more than 70 percent of government expenditures, they only collect about half of the tax revenue.24 Transfers from the central government address some of this gap, but this fiscal misalignment drives much of their reliance on borrowing and, more recently, land development. Giving local authorities access to more reliable revenue sources and a larger share of the fiscal pie is necessary to ensure their long-term financial sustainability.

At the same time, local officials were until recently evaluated almost entirely by their ability to produce economic growth. This incentive structure has been integral to China’s economic success over the past three decades, but it has also come at the cost of creating a system that favors short-term growth over (p.75) long-term financial, environmental, and social sustainability. Although much local investment is still necessary as China rapidly urbanizes and develops its transportation network, local officials’ incentives are more closely aligned with investing heavily than they are with investing productively, leading to overinvestment and overindebtedness. In addition, local governments are highly exposed to rising interest rates because much of their borrowing has to be refinanced annually, and some are ill-prepared to manage risks.

Dealing with Fiscal Misalignment

These concerns have not gone unaddressed. The economic reform plan announced following the 2013 Third Plenum meeting of the Party leadership gave pride of place to reforms intended to better align the fiscal system.25 A portion of spending on social services is to be transferred to the central government to lighten the burden on local finances, and local revenues are to be increased through the expansion of taxes that flow directly to local governments. The government also seems to recognize the need for more holistic assessments of local officials’ performance, announcing in late 2013 that a variety of factors, including local debt levels, will be incorporated going forward.26 This will hopefully encourage the development of better risk management systems and help to improve the structure of local debt.

While these steps are not a complete solution, they show that China’s leadership understands the vulnerabilities posed by the structure of the fiscal system and local officials’ incentives and that they are serious about remedying them. What is less clear is how the leadership intends to improve the transparency of local government debt. China’s leaders have moved to use more local government bonds, which will help because bond financing involves rating agencies and formal audits. In early 2014, the government selected a few localities and cities to launch a pilot bond-financing program amounting to 3.6 trillion renminbi to supplement their revenue needs. This has been extended to other localities, but the local governments included thus far were specifically selected because of their relatively strong financial positions. This has left unresolved the problem of improving the transparency of the localities most in need of reforms.

The main cause for some optimism lies in the June 2014 decision by the Politburo to authorize comprehensive reform of the fiscal system by 2016.27 The fiscal reform package aims to reduce these local budget deficits by expanding the value-added tax to include services and instituting new resource and property taxes. It also calls for the restructuring of local government debts and the elimination of loans backed by land. Multi-year budgeting may reduce incentives for off-budget revenue collection to meet short-term fiscal targets, and (p.76) local officials will be assessed in part on how prudently they manage their debts. While much work is still needed to make intentions actionable, political support for this initiative is still tentative given differing interests at the various levels of government.

Implementation of the fiscal reform agenda will take years, but the more immediate concern is the impact of declining revenue growth as the economy slows down, combined with restrictions on local government borrowings and land sales which have provided a large share of their revenues in recent years. In the absence of increased fiscal support from the central government, a major fiscal contraction could lead to an even sharper decline in GDP growth than the government has indicated. To offset the fiscal contraction at local levels, there has been a significant increase in the budget deficits in excess of the government’s announced intentions since 2015 along with increased funding from the policy banks such as the China Development Bank and greater use of private and public partnerships to support infrastructure needs.

Shadow Banking

Cutting across both corporate and local government debt is the issue of shadow banking. Broadly construed, shadow banking includes informal lending between individuals and companies, loans made by nonbank financial institutions like trusts and investment funds, and some common banking practices like bankers’ acceptances. Some would even include bond financing, although for our purposes this is not counted. In China, there is no formal definition of what activities constitute shadow banking, leading many to simply refer to all lending activities that occur outside of banks or off of bank balance sheets as shadow banking.

The most useful definitions of shadow banking, from the perspective of financial stability, are those that include all systemically important activities while omitting marginal forms of lending as well as more institutionalized channels such as bonds. In particular, activities that are strongly linked to the formal banking sector, namely WMPs and bankers’ acceptances, and those that are large relative to the size of the economy, namely trust products and entrust loans, are the key components of shadow banking. Minor activities, such as underground lending, are excluded here.28

Estimates that are in line with this definition place shadow banking at around 50–60 percent of GDP or around 25–30 percent of banking assets in China. These figures are not abnormal in international comparisons of shadow banking. The Financial Stability Board (FSB) estimates that globally, shadow banking averaged about 117 percent of GDP in the major OECD economies and 52 percent of banking assets, more than double the figures for China. In at least (p.77) three other major emerging markets, shadow banking represents a larger share of banking assets than it does in China (see Figure 5.3).29

China’s Debt Dilemma

Figure 5.3 Shadow Banking Comparisons.

Source: Financial Stability Board; JP Morgan Chase

Opinions on the issue of shadow banking in China are divided. Many financial experts have noted that shadow banking is more responsive to the needs of private enterprises that have traditionally lacked access to the state-dominated banking system and that those enterprises have played a major role in driving productivity growth and employment.30 The People’s Bank of China estimates that half of all the firms it regularly surveys have accessed some form of shadow banking.31

Others are alarmed by the rise of shadow banking in China because it is widely perceived to be more risky than traditional bank lending, which is subject to more stringent oversight. As with the broader debt, concerns about China’s shadow-banking system often focus on its rapid growth rather than its absolute level. Shadow-banking activities in China expanded dramatically since the end of the credit-fueled stimulus in 2009, accounting for roughly a quarter of the outstanding credit stock until recently.32 Much of the growth in shadow banking was driven by the surge in property related financing. In 2014, shadow banking was scaled back significantly as the property market cooled off and local governments turned to bond financing to reduce their debt burdens. More recently, shadow banking has resurfaced in response to movements in the property market and a rise in WMPs being issued by the smaller banks as a means to secure funding to increase their loan-making capacity.

Regardless, rapid growth of shadow banking is not atypical of emerging markets in recent years. According to the FSB, seven major emerging market countries have experienced growth above 15 percent, and China’s pattern is broadly (p.78) similar but more affected by property-related activities. Such growth rates should not be considered inherently problematic for countries developing their nascent shadow-banking systems from a very low base.

Risks behind the Numbers

While such aggregate numbers make for good headlines, they are not particularly helpful for assessing the risks associated with shadow banking. There is much more to the story. An implication of the term “shadow banking” is that diverse and distinct forms of nonbank credit can be grouped together under the same heading and thought of in the same way. In reality, each form of credit exhibits a dramatically different risk profile. Pointing to the riskiness of one form of shadow banking—as some of the most vocal critics do—and then citing the overall amount of shadow banking gives a misleading perception of the magnitude of the risks.

Broadly, there are two ways in which a shadow-banking sector can pose a risk. The first is direct: credit risk is increased by lending to financially weak borrowers. For this to become a serious issue, such lending must also be large in magnitude so that the potential losses are significant relative to the economy. The second form of risk comes when a shadow banking sector is strongly interconnected with the rest of the financial system. This channel was critical to transforming relatively modest losses on mortgage portfolios in the United States into a systemic financial crisis in 2008.33 In China’s heavily bank-based financial system, the primary risk comes from interconnectedness between shadow banking and the commercial banks.

Each form of shadow financing—entrust loans, bankers’ acceptances, trust companies, and WMPs—should be analyzed regarding risks and on its own merits. Only a fraction of these activities are really risky (see Box 5.1).

Alongside the high-risk, high-return products that draw most of the attention are a vast number of relatively low-risk investments that play healthy and productive roles in facilitating economic activity. Some shadow banking activities pose no extraordinary risks: entrust loans cannot easily spill over to impair banks’ balance sheets, and bankers’ acceptances are not acutely risky. The real concerns are more narrowly concentrated in the activities of trust companies and banks’ WMPs, although even here the risks can be overstated.

In reality, the much-discussed, high-risk components of the shadow banking system are overhyped. All forms of shadow banking amounted to a total of 84 percent of GDP in 2014. The high-risk components of shadow banking—concentrated among WMPs and trust products and accounting for about 18 percent of the total—are unlikely to have exceeded 15 percent of GDP or (p.79) (p.80) about 6 percent of bank assets (see Figure 5.4).34 However, the surge in the issuance of WMPs since 2015 to attract household savings has led to renewed concerns about the quality of the loans and assets being used to support the WMPs.

China’s Debt Dilemma

Figure 5.4 Components of Shadow Banking.

Source: People’s Bank of China; China Banking and Regulatory Commission; China Trust Association; author’s calculations

Granted, there are second-order financial risks associated with the shadow banking system, and potentially dangerous situations could arise, such as a vicious cycle in which the unraveling of some portion of shadow banking slows economic growth. Moreover, the authorities have not always been able to deal with such risks appropriately. The consequences could then damage the fiscal health of marginal borrowers, potentially leading to wider systemic consequences. A cascade of improbable events would have to take place for this scenario to happen on a scale that might lead to havoc, and as a whole, this is highly unlikely to occur.

The Workout

Of course, there is always the fallacy of the heap: each individual component of the financial system does not look overly menacing, but the combination of the various risks together could pose a threat. To assess whether the heap is truly more menacing than its individual components, there are stress tests and scenarios that should be explored.

A number of scenarios come from the past; this is not the first time China has faced serious debt strains. Throughout the 1990s, nonperforming loans at China’s banks were steadily rising as a result of excessive lending to poorly managed SOEs. The official nonperforming loans of SOCBs reached their peak in 1999, when they accounted for more than 30 percent of loans and about (p.81) 29 percent of GDP. Unofficial estimates ranged up to as much as 40–50 percent of total loans.35

China’s current challenges may be more complex, but the financial situation in the late 1990s was more severe, and even then the difficulties proved manageable. The government created four asset management companies to buy up nonperforming loans at face value. The central government also injected substantial amounts of capital into the biggest SOCBs so they could write off many of the remaining nonperforming loans. By 2005, the total face cost of these and other efforts to restructure the banks had reached nearly 4 trillion renminbi, or over 40 percent of GDP in 1999.36

Although the direct cost of the bailout was immense, it allowed the banks to return to lending and allowed economic growth to accelerate over the coming decade. It is difficult to disentangle the effects of the bailout from other actions that were taken, but it seems likely that the bailout process was successful in forestalling any major growth slowdown and that reforms, along with China’s accession to the WTO, were subsequently responsible for the acceleration of the growth rate after 2001. As the banks’ balance sheets expanded with new and better loans, nonperforming loans as a share of total loans steadily declined to below 1 percent by the end of the decade.37 All of this occurred in the context of a modest deleveraging between 2003 and 2008 when nominal GDP growth was outpacing credit growth and gradually pushing down China’s debt-to-GDP ratio.

So what are the prospects of a repeat of this successful, if costly, cleanup of the financial sector? This time growth alone cannot solve the problem. The days of double-digit growth and strong external demand are gone. Nevertheless, one can be cautiously optimistic. Even the most pessimistic current estimates of credit losses fall far short of what was observed in the late 1990s and early 2000s, which passed by with no serious macroeconomic fallout.

Although the official number for nonperforming loans is less than 2 percent as of mid-2016, a number of comprehensive exercises of possible scenarios have been done assuming that actual nonperforming loans might be in the 10–15 percent range eventually.38 These simulations suggest that credit losses might lead recapitalization costs amounting to 10–20 percent of GDP, which would not represent an unmanageable burden for the government.39 China’s financial and fiscal metrics simply do not point to a looming “Lehman moment,” despite all the periodic warnings to the contrary.

The IMF’s recent study on China’s financial risks tries to develop a better estimate of potential nonperforming loans as a trigger to a financial crisis. To the official number of around 2 percent of the loans outstanding, the IMF adds a set of loans that are potentially at risk and concludes that possible losses might amount to as much as 7 percent of GDP. Nevertheless, the IMF says that “they (p.82) are manageable given existing bank and policy buffers and the continued strong underlying growth in the economy.”40

The IMF’s views, however, have become more worrisome recently. Its 2016 monitoring report was less sanguine in noting: “The near-term growth outlook has improved . . . But the medium-term outlook is clouded by continued resource misallocation, high and rising corporate debt . . . and the increasingly large, opaque and interconnected financial system. The apparent challenges . . . add to concerns that China may exhaust its still-sizable buffers before the economy changes course sufficiently.”41

Clearly, tough actions are needed to curb the borrowings of local governments by strengthening their revenue base and restructuring their debt burden by converting bank loans into longer-term and lower-interest bonds. Fortunately, the corporate debt problem, while large in magnitude, is concentrated among a few specific activities and a small set of the larger SOEs, most notably the steel and coal sectors. In 2016, plans were initiated to curb lending for new steel and coal projects that did not meet national objectives and for firms that could not service their borrowings.42 The consequence is that some bankruptcies will need to take place and in that anticipation, new safety net programs have been created to assist the localities and firms with the costs.

Property Market Correction

Although financial woes are unlikely to bring China to its knees, an overbuilt property market can and is having a significant impact on short-term growth. Over the past decade, land prices in China have surged nearly fivefold in renminbi terms (about 6.5 times in dollar terms) according to the Wharton/NUS/Tsinghua Chinese Residential Land Price Index while the construction sector has expanded from 10 to 13 percent of GDP (see Figure 5.5).43 With such a dramatic increase in land and property prices and a glut of housing, this has understandably led to concerns that China may be experiencing a property bubble. These concerns were brought to a head by deteriorating sales figures and some price cuts in 2014, but from late 2015 into 2016 prices surged again in selected major cities with the latest round of monetary easing and an easing in ownership eligibility.

China’s Debt Dilemma

Figure 5.5 Land Price Increases.

Source: Wharton/NUS/Tsinghua Chinese Land Price Indexes; author’s calculations

A correction will probably occur at some point, but the impact is less likely to manifest itself in sharp price declines than in a prolonged slowdown in construction-related investment, especially in China’s second- and third-tier cities. Unlike other bubble-afflicted economies, growth in China’s land prices coincided with the emergence of a real property market that did not exist until a process for privatizing housing was initiated in the late 1990s. Because of this, (p.83) the sharp rise in property prices is more indicative of the market trying to establish appropriate prices for an asset whose value had previously been hidden by the socialist system, a pattern also observed in Russia after the fall of the Soviet Union.44 Although this does not rule out the possibility of a more “traditional” bubble, it does suggest that much of the rise could reflect the true underlying value of land. Further, it means that rapidly rising land prices alone cannot be interpreted as evidence of a bubble.

Further, there are strong fundamental drivers of urban housing demand that suggest China suffered from undersupply until a few years ago. Over the past decade China has been experiencing the largest population movement in history with an average of around twenty million migrants a year moving into urban areas, driving exceptionally strong demand for new housing.45 Similarly, explosive growth of urban wages has increased the affordability of housing despite rising prices and has driven massive upgrading demand as households seek out more spacious and modern apartments. Even more demand comes from the need to replace old communist-era housing stock.

Thanks to a construction boom following the GFC, China’s housing supply, however, has overshot the already substantial market demand in the post- GFC years. The oversupply of housing varies regionally, with the excess much more serious in the smaller cities than in the megacities.

Widespread distortions are also artificially inflating demand for property. For one, Chinese households have limited investment options; the closed capital account leaves few avenues for savers seeking returns higher than savings deposits can provide. Real estate is treated as an investment vehicle in China to fill the gap. According to the China Household Finance Survey, 18 percent of households own more than one home, suggesting that demand for property (p.84) as an investment vehicle is substantial.46 Moreover, the fact that China does not tax property, aside from ongoing pilot programs in Shanghai and Chongqing, means that there are lower costs to purchasing and holding unused property. Much of this activity had been curbed in recent years as the government has gradually tightened restrictions on multiple home ownership and improved mortgage standards, but these restrictions have been lifted and reinstated depending on the locality.

Overall, a correction is necessary, especially in the secondary and tertiary cities, and the investment incentives that fed the bubble curbed to encourage a continued decline in construction activity. It is difficult to evaluate the balance between the fundamental drivers of the expansion of the property market and irrational distortions, making a confident assessment of how severe the correction might be impossible. Still, there are some reasons to believe that the correction will not be financially destabilizing for either households or the banking sector.

First, the trends in land and housing prices in China are inconsistent with the typical pattern of a bubble. In a typical bubble, investors buy not because they see value in what they are buying but because they expect the price to continue rising. Thus, when prices show signs of falling (or even just slowing) growth, investors rush for the door and cause a collapse.

Prices in China have fallen in the past such as during the GFC and in 2011, followed by rebounds after the GFC and in 2012 and now again in 2016. These rebounds suggest that rising prices were being supported by something more real and persistent than “irrational exuberance.” This also suggests that the 2012–2014 levels may represent a reasonable floor, implying that any correction is unlikely to be more than 10–20 percent depending on locality. Such a fall would not have serious economic consequences and is dwarfed by the 30–50 percent collapses in the United States and Japan.

The other reason to be relatively sanguine about the severity of a price correction is that China’s property market is not highly dependent on leverage. Since down payments on property as a share of the purchase price are much higher in China than in the United States, it is less likely that banks will be drawn into a foreclosure process in the event of a major downturn.47 The results of the China Household Finance Survey indicate that even after a 30 percent decline in prices, only 3 percent of households would be underwater thanks to high down payments and the equity accumulated over the course of their ownership.48 The highly leveraged property developers that account for the other third of banks’ direct exposure are more concerning. Although those developers have been building up large liquidity buffers, some will certainly default given a significant correction, although this will not destabilize the financial system.

The strength of the household balance sheets and its limited exposure to the property sector has led the Bank of China to estimate that even a 30 percent (p.85) drop in real estate prices would have a negligible impact on banks’ nonperforming loan ratios.49

While the likely price correction may not be a major issue, scaled-back construction is having a negative impact on economic activity. Construction and real estate have been gradually rising as a share of GDP over the past three decades (see Figure 5.6). As with property prices, these sectors have not exhibited the pattern common to other bubble economies during the AFC—such as Korea or Malaysia—of a very sharp increase in share over a short period. However, amounting to 13 percent of GDP as of 2013, construction and real estate have become important components of China’s economy. And accounting for related industries, such as steel, cement, and construction equipment, would show that construction’s contribution approaches 20 percent of GDP. This makes China’s economy vulnerable to a construction downturn.

China’s Debt Dilemma

Figure 5.6 Construction Share of GDP.

Source: CEIC; UBS Investment Bank; author’s estimates

That downturn has been underway for several years already and will have likely subtracted two to three percentage points from GDP by the time it is over. But the actual impact of the correction on GDP growth is likely to be moderated because the entire correction need not occur in a single year and because increases in infrastructure investment are compensating for a portion of the decline in housing construction. Demand is also likely to rise as China’s urbanization plan is further implemented, which will reduce the magnitude of the adjustment that must take place.50

As a result of these factors, it would be reasonable to expect GDP growth to decline to 6 or even 5.5 percent over the next year or two (2017–2019) as the property sector continues to work through the oversupply of housing. But the darker scenarios in which growth collapses to 3 percent or lower are highly unlikely.

(p.86) Many bears on China retort that even if the current situation is manageable, it is just a matter of time until China hits its debt constraint. Some argue that the only way China can avoid a financial crisis is for growth to collapse to the low single digits.51 Similarly, the Fitch Ratings Report in 2013 elevated concerns about shadow banking and ever-rising debt levels.52 The argument being made is that the only thing that has kept growth so high recently in China is the even faster growth of credit.

To the extent that growth has become solely dependent on credit-fueled investment with a sharp drop-off in returns, this line of reasoning is plausible. However, one need not be so pessimistic about the economy’s potential to generate more productivity-driven growth. Nor should one overlook the role that credit has played in establishing market values for land-based assets whose true worth was blurred by poorly defined property rights in China’s evolving socialist system.

Property Market and Investment Rates

The more pessimistic narrative misunderstands how credit is being used in China. Much of the credit surge has been financing rising prices for property and other assets, but such increases are not included in calculating GDP growth. If these asset price increases are sustainable, however, current concerns over the debt buildup are exaggerated.

Here, the definitional difference between fixed asset investment (FAI) and gross fixed capital formation (GFCF) becomes important. Both concepts are measures of investment, but FAI measures investment in physical assets, including land, while GFCF measures investment in new equipment and structures, excluding the value of land. While GFCF contributes directly to GDP, only a portion of FAI shows up in the GDP numbers.

For some time, the distinction between the two concepts did not matter in interpreting economic trends because the two measures moved in lockstep in the national accounts, reaching 35 percent of GDP by 2003. Since then, the two have diverged, and GFCF now stands at around 45 percent of GDP while the share of FAI has jumped to 80 percent (see Figure 5.7). According to Goldman Sachs, fully two-thirds of this divergence can be attributed to growing differences in asset prices, particularly the increasing value of land.53

China’s Debt Dilemma

Figure 5.7 Investment and Growth Impact.

Source: World Bank World Development Indicators; author’s calculations

Overall credit levels and especially shadow banking have increased in line with the rapid growth in FAI rather than the more modest growth in GFCF. Given that the major distinction between the two measures of investment is the inclusion of land-related transactions, including price increases, this suggests that such transactions accounted for an increasingly large share of credit. In light (p.87) of the fivefold increase in the price of land over the past decade, it is not surprising that there has been a sharp decline in the impact of credit on GDP growth since it essentially has been facilitating the purchase and transfer of land-related assets whose prices have been soaring.

While some of this was wasted on speculative real estate projects, including the many examples of ghost towns, the bulk of it represents financial deepening and the unlocking of the hidden value of land. Once those values have been market validated, land price growth and the amount of credit being channeled to these uses will level off. That current property prices are broadly sustainable is supported by comparisons with property markets elsewhere. Few realize that property prices in Beijing and Shanghai in 2014, for example, were still only about half of the levels of New Delhi and Mumbai.54 Moreover, affordability has been increasing as incomes rose faster than property prices. Eventually, China’s property market needs to stabilize to facilitate a gradual shift in the allocation of credit back toward growth-enhancing investments.

Solving the Debt Problem through Productivity Gains

The prolonged slowdown in China’s economy has generated a fierce debate about whether the country needs a new “growth model.” All economies, however, are guided by the same growth models developed decades ago showing that growth depends on increasing investment and labor along with productivity or technological change. These principles have not changed.

(p.88) The problem is that productivity of investment in China has fallen significantly since the GFC.55 Declining returns on investment are inevitable as an economy matures, but China’s decline has been more rapid than usual because of the distortive effects of its huge stimulus program. Addressing these distortions would lead to a significant rebound in productivity.

Some observers have argued that there is a trade-off between near-term growth objectives and implementing reforms. However, the trade-off is overstated. There are still significant gains to be realized from the more efficient use of labor and other resources. The challenge for Beijing is increasing productivity so the economy can grow at a more sustainable rate for the rest of this decade without relying on ever-increasing debt. China’s proposed Third Plenum reforms provide the basis for moving forward.

China’s Third Plenum Reforms Offer Solutions

Every ten years, after the new leadership is designated, a special session of the Communist Party, called the Third Plenum, is held to lay out policy initiatives. The Third Plenum for Xi Jinping and the other members of the current seven-person standing committee which forms the highest decision-making body in China was held in November 2013.

The summary decision document for that session highlighted fifteen key themes for reform covering sixty areas for action. The document rightly does not mention rebalancing between consumption and investment but does refer to relying more on domestic demand—which could be either consumption or investment—and increasing productivity.56 This position is broadly on the mark. The Third Plenum proposed three major options for increasing productivity: a more efficient urbanization process, enterprise reform, and a more rational regional allocation of public investment.


The growth-enhancing part of the Third Plenum comes partly from setting out the broad objective of narrowing the rural–urban divide, which was detailed in the “New-style Urbanization Plan (2014–2020)” announced in March 2014. The new plan provides a framework for creating more equitable and environmentally sustainable cities. Objectives include increasing the urbanization rate to 60 percent by 2020 while providing more, but not all, migrant workers with full residency (hukou) rights.57 Because most migrants do not have access to the social services and other opportunities for established residents, official urbanization numbers have overstated the “real” urbanization rates in China.

(p.89) Smaller and medium-sized cities will now have more flexibility to absorb new migrants, but there is an unfortunate stipulation that the size of the largest cities would be “strictly controlled.” A secondary objective is to improve the efficiency of the urbanization process by discouraging urban sprawl and unproductive investments. Domestic demand would be stimulated by the construction of better local transport networks and connecting some three hundred cities to high-speed rail. Weaknesses in the plan include lack of specificity on how these objectives would be met, including financing options and restricting labor flow to the largest cities. The latter is unlikely to succeed since migrants are attracted to where the best jobs are and these have been in the largest cities where the potential productivity gains from urbanization are higher.

The tendency in the past to treat rural and urban areas as separate economic entities has added to the inefficiencies and exacerbated inequalities. This illustrates the continued potential for securing productivity gains from a better-managed urbanization process and moderating spatially driven income differences. Thus the package of Third Plenum reforms, if implemented aggressively, dealing with rationalizing land markets, ensuring more equitable access to social services, and liberalizing labor migration through hukou reform has the potential to ratchet up productivity-driven growth and promote equity.58 This would help capture the large differences between the productivity of workers in rural areas and their urban counterparts. Although China has been urbanizing rapidly, some 44 percent of people remain in rural areas, which suggests that potential productivity gains are still substantial.59

Ironically, if Beijing succeeds in these initiatives, continued rural to urban migration would make rebalancing less likely in the near term since these structural shifts tend to reduce labor’s share of income and hence the consumption share of GDP. Yet by maintaining rapid economic growth, these shifts would help sustain China’s unprecedentedly high rate of consumption growth, further improving the living standards of the average Chinese citizen.

SOE Reform and the Private Sector

Allowing the private sector to play a more prominent role could also unlock massive gains in productivity. This has been a recurring theme over the past decade, but the case for empowering the private sector has never been as strong as it is now. Addressing productivity differences between private and state-owned firms did not matter as much when returns on assets were rising for both groups and differences were narrowing in the years before the GFC. Both cohorts took a hit during the crisis, but rates of return for private firms have since rebounded sharply, hitting 11 percent before falling to 9 percent, while the rates of return for state-owned firms have fallen to 4 percent (see Figure 5.8). This difference of (p.90) around five percentage points illustrates the potential productivity and growth benefits that could be secured with reforms.

China’s Debt Dilemma

Figure 5.8 Private and SOE Profitability.

Source: CEIC; author’s calculations

Reforms that simply call for leveling the playing field between state and private firms will not increase productivity significantly. Liberalizing interest rates and opening up credit allocations to more private firms can help, but bolder policy actions are needed. These include getting the state out of a range of commercial activities and opening up other areas, especially services, for private entry by both domestic and foreign firms.

The government’s intentions to reform the enterprise sector were outlined in a September 2015 policy statement and subsequent actions. The statement drew a somewhat tepid public response given its lack of details and intentions to shield the largest and more strategic SOEs from privatization while allowing for minority private participation. It also indicated a reluctance to shed poorly performing firms. But the statement also provided opportunities for improving the performance of the commercially oriented SOEs and holding managers more accountable while also allowing personnel policies to reflect business practices.

The major ambiguities lie in how classification of firms will be handled and the way that newly created investment or holding companies will operate. The intention is to classify SOEs into public services and commercial subcategories that will be treated differently regarding the extent of state involvement and control. But the decision as to which category firms will belong to is largely determined by the firms themselves and by local officials with interest in protecting the status quo. The investment company referred to as State Capital Investment and Operating Companies could, in theory, play an active or passive role in how a firm operates but thus far there is little evidence that a strong push (p.91) toward reforms will emerge in a system where insider control remains largely unchanged.

There remains an urgent need for a major restructuring of SOEs operating in areas with excess capacity, notably the heavy and commodity-intensive industries such as steel and power generation. The reason for the poor performance of these SOEs is the decline in their “turnover” rate for inventories, which indicates excess capacity and delays in cutting back production. Consolidation and some bankruptcies are necessary. This intention is part of the government’s so-called supply initiative announced in early 2016, but the pace of implementation has been slow.

Reforms to curb the privileged position of SOEs would address many of the vulnerabilities in China’s financial system. Most SOEs benefit from explicit or implicit government guarantees that give them and their creditors few incentives to limit their borrowings. This has made SOEs the primary bad actors driving the excessive accumulation of corporate debt. Curbing them will free up capital for more productive small and medium-sized private enterprises (SME). But for this to happen, opening up protected activities to private firms—both domestic and foreign—is critical. This is particularly important in services since China has one of the most restrictive investment regimes in the world (see Chapter 8).

Distorted Regional Investment Allocation

Finally, productivity could be enhanced by rationalizing the allocation of public investments across regions (see Chapter 4). Currently, investments in the interior provinces, especially the far west, have been given priority because of political as well as equity concerns. This strategy has encouraged overly elaborate infrastructure projects and excess property construction. Although these investments have had some success in reducing regional disparities, they are a costly remedy since economic returns on most projects in the far west are much lower than along the coast. There is more to be gained by facilitating migration of labor from isolated regions rather than by trying to channel more infrastructures to those areas.

Whether China will implement the necessary reforms to improve the efficiency of the urbanization process, allow the private sector to play a more prominent role, and rebalance its regional investment strategies remains to be seen. As a general principle, the Third Plenum policy statement called for the market to play a “decisive role” in the economy but also signaled the contradictory intention that SOEs would continue to play a “dominant” role. Should the allocation of resources be increasingly guided by market principles and the various productivity-enhancing reforms identified are rigorously implemented, together (p.92) they could boost China’s growth rate by up to one to two percentage points annually, making the March 2016 announced growth target for the Thirteenth Five Year Plan of 6.5 percent achievable in principle.

Fiscals Reforms to Increase Domestic Demand

Many of the distortions in China’s economy have come to be reflected in the current financial problems, but their origins lie in its broken fiscal system. The privileges of SOEs have encouraged irresponsible behavior that has generated excess capacity, encouraged overbuilding, and accounted for much of the growth in corporate debt. Though China will likely avoid a hard landing, it must enact more decisive fiscal reforms to prevent the country’s current problems from recurring.

Without a revamped fiscal system, the government remains excessively dependent on bank credit for public spending. Many of the recent reforms, including eliminating controls on interest rates, have focused on financial liberalization. The general assumption for more than a decade has been that China’s interest rates were too low, but with financial liberalization they have instead fallen since the GFC, suggesting that they actually may have been too high (see Box 4.1). Given China’s fiscal and financial system, interest rate liberalization will do little to inhibit the unsustainable accumulation of local government debts. Instead, the budget must be strengthened and government revenues increased. Shifting the responsibility for funding public services from the banks back to the fiscal system would also foster greater transparency and accountability and thus help address corruption.

However, the short-term impact of curbing land sales of local governments on top of the economic slowdown is taking its toll on fiscal revenues. The consequences will require a delicate balancing act, coupling some monetary easing with larger than anticipated fiscal deficits if GDP growth is to be kept close to the official targets for 2017 and later. This means that even with the requisite reforms, the debt-to-GDP ratio will continue to rise for at least another year or two.

Fiscal reforms are also essential to solving the problem of inadequate domestic “demand.” Unique to China, the demand problem is that households have less control over assets, notably land and key natural resources, which the state owns. Thus, compared to typical market-based economies, households in China derive less spendable income from nonwage sources in the form of dividends, rents, and transfers. Income from property amounts to around 5 percent of disposable income in China, whereas the average for other countries tends to be around 10–20 percent. Transfers from the government amount to less than 10 percent (p.93) in China but average around 25 percent for other countries.60 The burden for increasing consumer demand rests with altering the role of the state in providing services and transfers for households in ways that are market friendly but also respect China’s state-dominated economy.

Surprisingly for a socialist economy, China’s government expenditures as a share of GDP lag far behind OECD countries.61 Consolidated government expenditures are less than 30 percent of GDP and, even after adding expenditures financed by off-budget revenues and land sales, total expenditures are about 35 percent of GDP compared with 45 percent for OECD economies. Further, the proportion of government spending that goes to social services and transfers is only about two-thirds the level of comparable middle-income economies.

These fiscal reforms would provide a stronger revenue base, realign social services responsibilities and allow increasing government expenditures to provide the necessary demand to utilize existing capacity. Together with productivity-enhancing reforms, this would offset the loss in demand caused by curbing wasteful investment spending. A China that better balances the supply and demand aspects of growth would be capable of growing in line with targets for the remainder of this decade and beyond.

Looking Forward

The increasing pessimism these days is the result of the continued decline in monthly economic indicators along with renewed concerns about China’s rising debt-to-GDP ratio and reemergence of shadow banking. This should not have been a surprise given the time required to work off its excess property stock and reduce capacity in the heavy industries.62

China’s slowdown is the result of a double whammy—a combination of a longer-term structural decline typical of a maturing economy on top of a shorter-term cyclical contraction in the aftermath of the GFC. While its debt problem is serious and needs to be addressed, it is highly unlikely to produce the crisis that many have been suggesting. For the moment, Beijing has little choice except to let the cyclical downturn play itself out while tightening up on financial management and strengthening accountability to reduce the risks of moral hazard. But it also needs to move forward on the necessary productivity-enhancing measures and fiscal reforms to increase demand if a moderately rapid growth path is to be sustained.


(2.) “The Coming Debt Bust,” The Economist, May 7, 2016.

(3.) David Dollar and Bert Hofman, “Intergovernmental Fiscal Reforms, Expenditure Assignment, and Governance,” in Public Finance in China: Reform and Growth for a Harmonious Society, eds. Lou Jiwei and Shulin Wang (Washington, DC: World Bank, 2008).

(4.) Yukon Huang and Canyon Bosler, “China’s Debt Dilemma—Deleveraging while Generating Growth,” Carnegie Endowment Policy Paper, September 2014.

(5.) Wang Tao, “Three Big Questions and the Most Important Chart,” UBS Macro Keys, January 2014.

(6.) That China’s debt is relatively high is not particularly surprising for a country with such a high savings rate and a bank-dominated financial system, both of which are traits associated with high debt.

(8.) Martin Kessler and Arvind Subramanian, “Is the Renminbi Still Undervalued? Not According to New PPP Estimates,” Peterson Institute for International Economics Real Time Economic Issues Watch (blog), May 2014.

(9.) Stijn Claessens, Simeon Djankov, and Lixin Colin Xu, “Corporate Performance in the East Asian Financial Crisis,” World Bank Research Observer, February 2000.

(10.) Jay Bryson, “Does China Have a Debt Problem?,” Wells Fargo Special Commentary, September 2013.

(11.) Mali Chivakul and W. Raphael Lam, “Assessing China’s Corporate Sector Vulnerabilities,” IMF Working Paper WP/15/72, March 2015.

(12.) Thomas Gatley, “How Big Is the Zombie Army,” Gavekal Dragonomics, March 31, 2016.

(13.) China Council for International Cooperation on Environment and Development, “State Council Urges to Cut 80m Tons of Steel Capacity in 5 Years,” October 25, 2013.

(14.) Ryan Rutkowski, “Will China Finally Tackle Overcapacity,” Peterson Institute for International Economics, China Economic Watch (blog), April 2014.

(15.) Yukon Huang, “China’s Productivity Challenge,” Wall Street Journal, August 2013.

(16.) Kenneth Ho et al., “The China Credit Conundrum,” Goldman and Sachs Portfolio Strategy Research, July 26, 2013.

(17.) Andrew Batson, “Fixing China’s State Sector,” Paulson Institute Policy Memoranda, January 2014.

(18.) Kenneth Ho et al., “The China Credit Conundrum.”

(19.) The city of Xinyu, which receives 12 percent of its tax receipts from LDK Solar, arranged to pay off all $80 million of the solar firm’s debt rather than allow it to default in 2013. Similarly, when the city of Wenzhou’s vibrant underground financial system began to collapse a few years ago, the local government pressured state-owned banks to step in and bail out many of the private firms that had relied on informal lending markets rather than allow their bankruptcies to become a drag on the local economy.

(20.) “Bursting China’s Credit Bubble,” Wall Street Journal, April 19, 2016.

(21.) Thomas Gatley and Long Chen, “Defaults Are Coming—Where, When and How,” Gavekal Dragonomics, April 2014.

(22.) Arthur Kroeber, “After the NPC: Xi Jinping’s Roadmap for China,” Brookings Institute, March 2014.

(24.) Yinqiu Lu and Tao Sun, “Local Government Financing Platforms in China: A Fortune or Misfortune,” IMF Working Paper WP/13/243, October 2013.

(25.) “The Decision on Major Issues Concerning Comprehensively Deepening Reforms in Brief,” China Daily, November 16, 2013.

(26.) Shannon Tiezzi, “Re-evaluating Local Officials Key to China’s Reforms,” Diplomat, December 2013.

(27.) Yukon Huang, “Squaring the Circle: How the Reforms Can Work,” China Economic Quarterly, December 2014.

(28.) Ideally shadow banking would be measured entirely from the asset side (trust loans, entrust loans, bankers’ acceptance bills, etc.) or entirely from the liability side (WMPs, trust products, etc.) to ensure consistency and minimize double counting. However, data constraints make such an approach impractical and would end up omitting some relevant forms of credit extension through shadow banking. This is a conservative definition that allows for some double counting to ensure comprehensive coverage and is likely to be an overestimate.

(29.) Nikolaos Panigirtzoglou, Matthew Lehmann, and Jigar Vakharia, “How Scary Are China’s Shadow Banks?,” J. P. Morgan Global Asset Allocation, January 2014.

(30.) “Wealth Products Threaten China Banks on Ponzi-Scheme Risk,” Bloomberg News, July 2013.

(31.) Suwatchai Songwanich, “Shadow-banking Poses Problems for China,” NationMultimedia.com, March 2014.

(32.) Kenneth Ho et al., “The China Credit Conundrum.”

(33.) Janet L. Yellen, “Interconnectedness and Systemic Risk: Lessons from the Financial Crisis and Policy Implications,” speech at the American Economic Association/American Finance Association Joint Luncheon, San Diego, California, January 4, 2013.

(34.) Some studies using a narrower definition of shadow banking come up with higher percentages of risky assets but this is the result of excluding from the total the less risky components.

(35.) Bank for International Settlements, “Strengthening the Banking System in China: Issues and Experiences,”Nicholas Lardy, China’s Unfinished Economic Revolution (Washington, DC: Brookings Institute Press, 1998).

(36.) Guonan Ma, “Who Pays China’s Bank Restructuring Bill?,” Asian Economic Papers, January 2007.

(37.) “Asset-Management Companies in China: Lipstick on a Pig,” The Economist, August 2013.

(38.) (p.230) McKinsey Global Institute, “China’s Choice: Capturing the $5 Trillion Productivity Opportunity,” June 2016.

(40.) IMF, Global Financial Stability Report (Washington, DC: IMF, 2016), 17.

(42.) Chuin-Wei Yap, “China Tries to Choke Off Steel and Coal Loans,” Wall Street Journal, April 21, 2016.

(43.) Wang Tao et al., “Bubble Trouble: Are We There Yet?,” UBS Global Research, May 2014.

(44.) Yukon Huang, “Do Not Fear a Chinese Property Bubble,” Financial Times, February 2014.

(45.) Wang Tao, Harrison Hu, Donna Kwok, and Ning Zhang, “What’s New About China’s New Urbanization Plan?,” UBS Global Research, March 2014.

(46.) Li Gan, “Findings from China Household Finance Survey,” January 2013.

(47.) The price rebound in 2016 has been supported in some localities by riskier forms of financing. Whether such activity will persist is unclear.

(49.) Nicholas Borst, “How Vulnerable Are Chinese Banks to a Real Estate Downturn?,” Peterson Institute for International Economics China Economic Watch (blog), April 2014.

(50.) Although China’s new urbanization plan anticipates slower migration to the cities than in the past decade, it intends to allow more migrants to register as urban residents, which would increase their demand for housing and other social services.

(51.) Michael Pettis, “Will the Reforms Speed Growth in China?,” China Financial Markets, January 2014.

(52.) Charlene Chu, Chunling Wen, Hiddy He, and Jonathan Cornish, “Indebtedness Continues to Rise with No Deleveraging in Sight,” Fitch Ratings Special Report, September 2013.

(53.) M. K. Tang, “Is Credit Losing Its Cyclical Growth Impact?,” Goldman Sachs Emerging Markets Macro Daily, May 2013.

(55.) Martin Wolf, “China’s Struggle for a New Normal,” Financial Times, March 22, 2016.

(56.) Yukon Huang, “How to Make Comprehensively Deepening Reform in China,” Financial Times, November 13, 2013.

(57.) Every Chinese citizen is given formal residency rights—hukou— usually according to where they were born. These rights provide access to public services such as education and health and grant eligibility for state-sponsored employment. Migrant workers who relocate to other localities for employment purposes are not usually accorded such rights and thus many do not bring their families with them since they would not have access to local social services and cannot buy a house, secure a driver’s license, etc. Such residency rights can be granted by local authorities upon application, but the guidelines for doing so have been strict.

(58.) See Steve Barnett and Ray Brooks, “Does Government Spending in Health and Education Raise Consumption?,” for analysis showing how increased budget support for social programs would also increase personal consumption of social services.

(59.) the World Bank, Urban China: Toward Efficient, Inclusive, and Sustainable Urbanization (Washington, DC: World Bank, 2014).

(60.) Kai Guo and Papa N’Diaye, “Determinants of China’s Private Consumption: An International Perspective,” in Rebalancing Growth in Asia, eds. Vivek Arora and Robert Cardarelli (Washington, DC: IMF, 2011).