A new study from the IMF claims that China’s ongoing credit boom is the longest on record, posing a significant threat to its financial stability and economic growth.
In an IMF Working Paper entitled “Credit Booms – Is China Different?,” Sally Chen and Joong Shik Kang point out that while China managed to shore up economic growth in the wake of the Great Financial Crisis via a heavy-handed stimulus program, this surge in credit levels has created major risk of disruption or impeded growth in future.
While China’s non-financial sector domestic credit-to-GDP ratio remained steady at around 135% prior to the GFC, Beijing’s stimulus package pushed it to 170% by 2011.
Credit levels continued to rise at a breakneck pace subsequently, with domestic non-financial sector credit hitting 235% of GDP by the end of 2016.
This rise has in turn driven a surge China’s credit gap, which is the deviation of the credit-to-GDP ratio form the historical trend, to around 25% of GDP. The figure is well ahead of the 10% threshold proposed by the Bank for International Settlements for achieving a maximum countercyclical buffer.
China’s current credit spree has also been accompanied by sharp declines in efficiency of credit expansion and continued misallocation of financial resources.
While around 6.5 trillion yuan in new credit could boost nominal GDP by around 5 trillion yuan per year in 2007-08, by 2015-16 the same volume of growth would require over 20 trillion yuan in new credit.
A key reason for this decline in credit efficiency lie in the fact that the less-efficient industrial sector accounts for around half of new credit, yet contributes only one-fifth of GPD in 2016, with the services sector making a contribution of over two thirds of GDP with a commensurate share of credit.
Less efficient state-owned enterprises account for around half of new credit, despite far lower profit levels compared to their peers in the private sector, and cumulative value added growth remaining only half that of private companies.
The regional distribution of credit extension has also contributed to reduced efficiency. While China’s northeastern rust-belt has seen its contribution to national industrial output fall in recent years, its relative share of credit in the industrial sector has still held steady.
Chen and Kang point out that China’s current, ongoing credit boom is by far the longest yet observed, having started in 2003 without a downturn, for an expansion now 15 years running.
This compares to a median duration for upswings in OECD countries of 7 to 12 quarters, and around 3 years for emerging economies.
“Total credit in China has expanded nearly uninterrupted since the 1990’s,” said the study. “Such expansion likely helped China avert painful growth contraction seen elsewhere in the aftermath of credit busts, but it has also allowed for underlying vulnerabilities to build further.
“International experience suggests that China’s current credit trajectory is dangerous with increasing risks of a disruptive adjustment and a marked growth slowdown…historical precedents of ‘safe’ credit booms of such magnitude and speed are few and far from comforting [suggesting] that China’s debt overhang, if left unaddressed, could pose risks to its financial stability and growth.
“We identified 43 cases of credit booms in which the credit-to-GDP ratio increased by more than 30 percentage points over a 5-year period…only five ended without a major growth slowdown or a financial crisis in the immediate aftermath.
“In addition, all credit booms that began when the ratios were above 100 percent – as in China’s case – ended badly.”
Other factors further heightening China’s vulnerability include a surge in the scope and complexity of bank balance sheets, which have expanded by 50 percentage points of GDP over the past three years to reach 310% of GDP, or almost three times the average for emerging markets.
The accompanying increase in the complexity and interconnectedness of bank balance sheets is also exacerbating risk, with significant mismatches in the maturity of assets and liabilities making the Chinese financial sector highly susceptible to a liquidity crunch.
“The WMP (wealth management product) sector invests more than half of its assets in the fixed income markets,” said the report.
“Bond market losses suffered by WMP’s could lead to bank balance sheet stress given the widespread perception of implicit guarantees of banks’ sponsorship of WMP’s.
“If a disruption to financing flows occurs, not only could the borrower face liquidation pressure, the loss could cascade down the intermediation ladder, reaching other financial products and institutions including the broader banking actor.”
Despite the highly precarious state of the Chinese financial sector following the country’s record-long credit boom, the IMF paper points to a multitude factors specific to China that serve to mitigate risk, such its current account surplus, low external debt and high savings levels.
China is not vulnerable to an external funding crisis the way other emerging markets have been, due to its consistent current account surpluses and low external debt levels.
China also has a high level domestic savings and a steady base of domestic deposits, with a low bank loan-to-deposit ratio of 72% in 2016, which could help avert a domestic funding crisis.
Rising asset values have driven an increase in the asset side of corporate balance sheets ahead of liabilities, leading to a decline in leverage as measured by the debt-to-asset ratio.
Other factors serving to mitigate risk relate to China’s heavily state-controlled economy, which continues to maintain a comparatively closed capital account and effective capital controls.
A low level of official government debt, which stood at 40% of GDP in 2016, would appear to give Beijing ample fiscal space to prop up both the banking system and broader economy in the event of a credit contraction, while the Chinese central bank is reasonably well positioned to provide liquidity against any funding stresses.
The IMF researchers nonetheless call for decisive policy action to end the “negative feedback loop between slowing growth, excessive credit provision and worsening debt service capacity.”
One of the most important measures would be dialling down the highly ambitious GDP targets that have long been part and parcel of Chinese economic policy, and serve to spur excessive credit growth.
Credit efficiency could be improved by launching a “comprehensive strategy” for reducing demand for less productive undertakings, while reform of financial regulation and supervision will raise transparency and curb leverage levels, especially if they crack down on the various forms of “regulatory arbitrage” still rife in China’s finance sector.
One sign of hope lies in the progress of China’s recent efforts to deleverage the financial system, with net issuance of WMP’s turning negative in the second quarter of last year, and total usage of the interbank repo market falling markedly.
‘The current period of stable financial markets and robust growth offers a unique opportunity for tackling these issues,” said the study.