Debt crisis in China?

By Henrique Schneider

Let’s face the facts: Japan has a ratio of debt to Gross Demographic Product (GDP) of over 220 percent. This means, to pay off its debt, the “Land of the rising sun” would have to work some 27 months relentlessly and dedicate all its economy solely to this aim. Italy, the U.S., France and Canada are around 100 percent. Therefore, why is the media world so shocked by China’s 50 percent? (For information’s sake: Korea’s debt-to-GDP ratio is below 40 percent.)

Well, for one thing, until 2012 Beijing was reporting a completely different number, 22 percent. Interestingly, it still does! Moreover, as China launched the largest fiscal stimulus program the world ever saw in 2008-2009, the mandarins explained that they were at liberty of spending 4 trillion yuan since their debt-to-GDP ratio was only 14 percent. The world looked in awe toward the East and accepted the magic of stimulus and debt.

Today, the picture looks quite different. There is no talk of stimulus anymore; there was some awkwardness as the International Monetary Fund (IMF) published a number completely different from Beijing’s official statistics; and there is a certain amount of bitterness in the People’s Bank of China, the central bank, as reform of the banking system seems to be stalled.

Debt, so what?

In the last couple of years, the importance of debt has been played down by debt-accumulating states. However, even if countries manage to service their debt (for example, paying interest rates), the level of debt itself is an important indicator for the state of an economy.

It is true that the Chinese central government as such has pretty low debt-to-GDP ratios. But provincial and prefectural governments don’t. Some cities are well past 100 percent! This is a consequence of the stimulus program: central government would make provinces and prefectures invest in huge infrastructure projects. In order to pay for them, the local level administrations had to accumulate debt. The problem is, these governments do not generate income of their own, so servicing and paying off debt comes of their regular budget making them cut costs for example in schooling or social welfare.

Also, state-owned banks were and are forced to lend money to state-backed corporations. Not only are the official interest rates tightly controlled by the government, but these leases had to be done way below the official rates. The consequences are first that state-owned companies are notoriously inefficient in the use of capital since they get money practically for free, second this inefficiency spills over to the banks that cannot guarantee returns on capital if they have to lend below market, and third this crowds-out good lending to small- and medium-sized companies that are more innovative and more efficient than state-owned. Banks will only lend at a premium in order to compensate for the losses in the state-mandated transactions.

Therefore, should even debt per se not be that bad (it is!), its ways still have negative effects on the economy. Another thing: a jump in debt to GDP ratio from 14 to 22 percent (taking the official numbers without provincial and prefectural data) in just five years should trouble everyone’s mind.

Doom? Unlikely!

Does this mean that China is doomed? Probably not. The central government and most importantly the central bank are aware of the situation the country is in. The question is how to seek a way out. The IMF, in its institutional hunger for regulation, urged China to enhance macro-prudential rules. Fortunately for China and for the world, Beijing is thinking about another path. If the mandarins are serious about the transformation of the economy toward a more sustainable and service-oriented path, the first thing China wants to do about its banks is to liberalize interest rates. This would allow them to measure and account for the level of risk of the economy. Once interest rates reflect risk, many problems are banned: lending will be more selective and pressure is put on capital to be efficient.

Then, and this is the hardest step for a centrally planned economy, China would have to allow markets to guide themselves. Turning its back to investments in infrastructure (and stimulus spending) is one ― laudable ― thing. But accepting that failure is inherent and important to free markets is even more important.

The “middle kingdom” is not in a debt crisis. Debt-levels, however, show that China’s economy has fallen into an efficiency-gap. Liberalization, namely of the banking sector, is the most promising instrument to return to the way of development. And China can do it. But: does it want to?

The writer is the chief economist of the Swiss Federation of Small and Medium Enterprises. His main interests are Korean and Chinese economies and politics. His email address is hschneider@gmx.ch.