China debt jitters made a comeback Tuesday, on the heels of a report claiming the country’s debt to GDP ratio hit a lofty 251% at the end of June. Cue the clamor over the world’s second-largest economy over-extending itself, with hypothetical outcomes ranging from hard-landing to global meltdown. In our view, though, this is a classic case of headlines overreacting to what is some fairly benign Chinese data—we won’t argue China is in perfect fiscal shape, but this statistic doesn’t spell doom for China or the world.
Details, as ever, are key. “Debt,” in this case, isn’t just government debt, which is most folks’ default (sorry) interpretation of “debt to GDP.” This figure includes all credit, public and private—traditional bank loans, corporate bonds and various shadow banking debt in addition to local, regional and federal government debt. Combining all these and trying to find some big takeaway about a country’s health, as you might intuit, is rather bizarre—the banking system isn’t the state isn’t the companies isn’t the people. Even in a People’s Republic. The notion any country’s outstanding credit hitting some arbitrary level is a snowball of financial problems ready to roll down the mountain is a tad misplaced. That’s abundantly evident if you compare China with the rest of the world. Based on this report’s data, at the end of 2013, South Korea’s debt was just north of 200% of GDP, Germany’s was a tad under, the US was at about 260%, and the UK was at 277% (and Japan, being Japan, shocked no one at 415%). Which all makes China look fairly normal—and not exactly at-risk, considering these countries are all growing, albeit to varying degrees, and not on the verge of debt crises. Japan might be a global laggard, but this statistic isn’t why.
But, some object, China is different! It isn’t as developed, and all that debt was really leverage to make things grow faster—and with that model petering out, China is “indebted before it has become rich,” leaving it extra vulnerable to slowdown and shock. There is a kernel of truth here—China’s debt-fueled stimublitz in 2008 and 2009 drove gangbusters growth, but it also left a supply glut in its wake. The steel, shipping and real estate industries are still dealing with the aftermath. However, the assumption this oversupply is a debt-fueled sinkhole is pretty misplaced. Consider the most widely cited example of excess, those fabled “ghost cities.” Those are largely there to accommodate the next wave of urbanization, which policymakers are pursuing aggressively. This is all very much a work-in-progress, which those taking a surface level view at China’s finances generally don’t see.
For global markets, what matters is whether China’s debt becomes a severe economic issue within the foreseeable future, like the next 12 to 18 months. Some compare that 250% debt to GDP ratio to the US on the eve of 2008, Japan before its asset bubble burst in the late 1980s and Korea before the Asian Financial Crisis and ask, “How could it not?” But these situations had their own unique fundamental causes, and none was expressly a debt issue, per se. To some, the Korean parallels might seem most apt since both are developing nations, but China is in a different position. Nearly all this outstanding debt is denominated in yuan, not a foreign currency, so China isn’t anywhere near as vulnerable as Thailand and Korea were in the late 1990s. For them, the iffy combo of dollar-denominated debt and fixed exchange rates was the root of the problem. China’s currency may have a fixed float, but foreign debt amounts to a tiny 4% of China’s entire debt load. This allows the government much more flexibility and time to deal with whatever issues might lurk under the surface.
As a general rule, debt is a problem only if the issuer can’t service it—if they can’t make interest or principal repayments. To assume the entire $26 trillion in outstanding public and private debt is at risk of default is a stretch. If it truly were a steaming pile of toxic sludge, we rather doubt investors would have lined up in droves Wednesday to buy China’s first new mortgage-backed security in seven years. Some fear for China’s $14.2 trillion corporate bond market, which saw its first onshore default in March, but one default does not a contagion make. Even with the government slowly removing its safety net, interest rates haven’t spiked to unmanageable levels. The widely publicized collapse of property developer Zhejiang Xingrun Real Estate in April went down in an orderly fashion. When the firm couldn’t repay a private debt placement, the underwriters stepped in and did their job (that’s how it’s supposed to work). Another feared default—a $65 million bond from Huatong Road & Bridge Group—was averted at the last second Wednesday, when Huatong apparently found enough money in the sofa cushions to pay all principal and interest due. Now, how it scrounged up enough spare change is a matter of some debate, but even if this was a double-secret bailout, it merely underscores the distinct unlikelihood of a corporate bond implosion. And whether or not the government steps in again (and for the sake of China’s long-term economic modernization, not stepping in would be more beneficial in the long run), even if defaults accelerated some from the pace of one (and two near-misses) every four months, that’s more a move toward the international norm than anything else.
None of this is to say all is rosy in China’s debt markets. But for stocks, the key question is whether China’s lingering issues are a surprise. And, well, they aren’t. Deep discussions of Chinese debt—whether in banking, shadow banking, state-owned firms, private firms, local governments, households or anything else—have circulated for years. Markets have long been aware of the many theories of potential outcomes, estimates of the extent of certain problems, and estimates of the economy’s and government’s ability to cope. China’s use of debt to finance growth has also been discussed for years—and so has the waning economic return on that debt. Heck, this is a big reason why the government is trying to set the world’s expectations for slower growth. The world has known for years that it takes more and more borrowed yuan to create one yuan in new GDP. Just as the world has long known about overcapacity in certain sectors. The existence of these apparent negatives isn’t meaningful for stocks—what matters is that officials are taking (sometimes aggressive) steps to address them. Markets are generally willing to take a longer-term view of matters like these, and they’re well aware China will hit some speed bumps as officials continue reengineering the economy for the long haul.
Officials are also taking steps to make it easier for local governments to continue servicing debt, which should further shore up confidence. At the beginning of the year, the National Development and Reform Commission (NDRC) announced the central government would allow local governments to roll over maturing debt by issuing new bonds at longer maturities, easing the immediate repayment burden. In May, the NDRC said China would allow 10 local governments to directly sell municipal bonds, with Guangdong being the first to do so in June, which should help them diversify away bank loans, addressing one of the thornier issues in Chinese debt markets.
China will probably continue going through some growing pains, normal for any developing country—even one as big as China. With fear so abundant today, expectations are low, and as China demonstrates its ability to weather the small bumps it inevitably hits along the way, stocks likely see some measure of relief.