China’s dystopian threat?

Please note this blog post was published over 12 months ago and so may not include the most up-to-date information, for example where regulation around investing has changed.

China’s dystopian threat?

Lionel Shriver’s fictional book, The Mandibles, presents a bleak future. Told through the Mandible family, the US, overwhelmed by debt, has turned into a failed state. The mighty greenback is confined to the bin and the US introduces a completely new currency, the Bancor. Correspondingly, all US citizens have a microchip embedded in the back of their neck allowing the state to control their finances.

Far-fetched? Perhaps not. In Hebei, a Northern province of China, an app is being rolled out named, ‘the app of deadbeat debtors’. The program tells users if they are within 500 metres of someone who hasn’t paid their debts. It can be accessed on Wechat, the country’s most popular messaging programme. This new development looks like the thin end of the wedge. Can you imagine the repercussions in a democratic society from such a move? However, in China there is more intrusion of privacy to come.

As usual, new initiatives operate with a motive to hand. In the land of economics, burgeoning levels of debt across China have created a need to act. For example, as a percentage of GDP, the corporate sector has expanded its borrowing to 160% of GDP. High, yes, but state-owned enterprises (SOE’s) form a large chunk of the debt so it is effectively an extension of state indebtedness. Because of this, economists often take these two sectors and add them together. Allowing for this oddity, the under reporting of data and the fact that China is both a lender, through state owned banks, and a borrower through SOE’s, the figure for total government borrowing may be as high as 300%.

Debt as a % of GDP: China and the US

Source: Bloomberg, February 2019

In view of the scale of borrowing the government is cracking down on the so called ‘shadow banking’ sector. Given the integration of China’s financial sector with the broader economy, regulatory policy is helping to mitigate potential systemic risk. The government is approaching this cautiously because it fears that restricting debt for expansion could lead to a slowdown in the Chinese economy; especially so now amid a backdrop of trade tensions with the US.

In the household sector, comprised of individuals, the rate of debt expansion is even more pronounced. Growing levels of debt by individuals is a function of wealth and confidence, but higher debt levels in households carry risks to financial stability over time and so influencing the level of borrowing is desirable.

Creating a social stigma around defaulting on debt, to limit damage to lenders, is something that governments in the West have opposed. However, China is moving in the opposite direction without any meaningful opposition. Steps taken by the courts to ‘out’ those not paying their debts, through an app showing their exact location, seems bizarre. Is there any justification for this approach? Moral hazard theory says people take more risk when they think someone else bears the cost of that risk. Perhaps, applying this theory, the app may work by making borrowers reflect on the personal cost from defaulting if, as a result, they are shunned by society at large. Stigmatising debtors in this way, to minimise moral hazard, seems a rough approach to take. Regrettably, state control in China means this new step is not out of the ordinary.

What do current levels of household debt look like in China and is the amount of debt today of sufficient scale to be of real concern? For context we compare China against the US. The US consumer is often referred to as the ‘consumer of last resort’, with a seemingly insatiable appetite for borrowing, so if Chinese household debt exceeds that of the US we can say the problem is real. Why? Well for a start GDP per capita (the nominal GDP divided by the country’s population) in China compared to the US is much lower.

Thankfully, from the chart below, we see the scale of borrowing is not yet of the same magnitude. The main concern is that household debt in China is closing the gap with the US– fast! In 2008 household debt in China was less than a billion dollars but it now exceeds $6bn, a growth factor of 6x. In the same period US household debt, hovering around £13bn, has hardly budged.

China v US household borrowing in the US

Source: Bloomberg, February 2019

Economic expansion using credit finance has become an obsession for China. It forms part of the Communist government’s social contract with the people in exchange for accepting central rule. After the global financial crisis, economies around the world struggled due to a lack of finance (liquidity). Under central government control China was able to deploy debt and boy did they use it! The banking system grew from $9 trillion in 2008 to $39 trillion by 2018. Sinking vast amounts of money into business and government infrastructure they got the economy moving again.

As mentioned earlier, shadow banking has been a force behind debt growth in China. It is estimated that about $10 trillion of the $30 trillion increase came from this source. Shadow banking is a system financed by high yielding asset management products, entrusted loans and peer to peer lending. This enables banks to offload assets from their balance sheets and make it easy for businesses to access finance for expansion, hence a boom in corporate debt levels.

So where does this leave China? Economically, China is transitioning from an emerging economy to a developed one. Debt finance provides the fuel for this to happen, and the authorities have once again injected more debt finance to help keep growth intact; as households feel wealthier and more confident they become less risk averse, able to borrow to spend. The authorities have the difficult job of managing this transition hence they are using whatever tools they deem necessary, including invading privacy.

In conclusion, debt levels in China are high and being monitored closely by the government. Shaming debtors may seem extreme to us. It may be effective, but the social consequences are probably not thought through. The new shaming app sits alongside other questionable shifts taking place in China, such as the wide scale introduction of facial recognition technology and blocking people from using transport who have poor social behaviour records. In Hangzhou, the capital city of China’s Zhejiang province, a new social credit system is rewarding pro-social behaviours such as donating blood, staying healthy and doing volunteer work. It also punishes bad drivers, smokers and government critics.

Lionel Shriver’s dystopian novel, set in the period 2029-2047, may be wrong in one important respect. If a currency microchip embedded in each person becomes reality, it seems more likely to be inserted in Chinese, not American, citizens.

With investing, your capital is at risk. Investments can fluctuate in value and you may get back less than you invest. Past performance is not a guide to future performance. Tax rules can change at any time. This blog is not personal financial advice.

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