China’s high level of domestic debt

In a recent economic update, “Fake News or Chinese Fortune Cookies”, we wrote about how China’s economy is performing better than generally expected. However, with signs of economic growth slowing and debt levels rising, there have been some concerns that stability is being threatened. We revisit China to discuss how they are progressing in transitioning their economy for the better; from revolution to evolution.

Revolution

In 2010, China as an emerging economy was booming and delivering double-digit economic growth. 8 years later the economy is still growing but at a decelerating rate. Today, the annual growth is 6.8%. Much slower but still resolute.

A slowdown in the economic growth rate for the Chinese economy is natural when one considers just how big the economy has become. The country has fuelled its growth initially through building a manufacturing empire, using its vast population to deliver lower quality goods using cheap labour. This helped them gain a competitive edge on the global stage, turning China into an exporting juggernaut.

More recently, China has upped its game through finding ways to produce better quality goods, some with a far greater IP (intellectual property) content. Trump claims that a large portion of this IP has been stolen from US companies!

By running a sizeable current account surplus on trade, the economy of China was particularly vulnerable as the world entered into a global financial crisis in 2008/09. This over reliance on trade war recognised by Chinese policymakers as potentially destabilising should a similar event happen again. To head off this threat, they wanted to stimulate greater internal dynamics. By deploying increased investment, predominantly through the issuance of debt through the banking system, they have been able to continue to promote growth and employment.

The chart below highlights China’s surge in debt as a percentage of GDP over the past decade, growing from a ratio of 162% in 2008 to 266% last year – even for an emerging country this is a high level. With growth fuelled, and apparently dependent on credit, the argument put forward by pessimists is that if credit begins to falter, so must China’s economic growth. The counter argument is that debt is held domestically and mostly in the corporate sector, thus it is a problem that can be dealt with by the China’s central bank. If the debt was held by international investors it would pose a different and more immediate threat – capital flight and a higher premium demanded causing borrowing costs to spike.  Debt is currently being reigned in but this is happening in a controlled way and being monitored for its effects on business confidence and economic activity.

Contributions to Debt as % of GDP

Source: Bloomberg, April 2018

China’s earlier growth revolution is transitioning. The natural order is for it to become an increasingly service-driven economy built upon increasing wealth. To some extent this is happening. The demand for labour keeps increasing and the labour participation rate (those actively looking for work) falling: by -0.5% last year. Added to a slowing rate of rural-urban migration, real wages have soared. This is raising standards of living helping to narrow the gap in contribution between investment and consumption with the latter growing in importance.

Evolution

Strides are being made to reshape the drivers of China’s economic growth. There is still, however, a long way to go. Private consumption provides an insufficient share of GDP to counter the economy’s reliance on exporting domestically produced cheap manufactured goods.

Finally, China’s aging population and poor healthcare systems encourages precautionary high levels of savings; a whopping 46.4% in 2017. If the government can transform its health care and education system, to one more aligned to standards exhibited in developed nations, households may be more inclined to save less and spend more in the future. Reshaping thinking on investment and manufacturing is expected to lead to a more evenly balanced economy. This will be prosperous for China and beneficial for their trading partners and will make Mr Trump happy.