As the IIF reported yesterday, in the first 9 months of 2016 global debt rose by $11 trillion, hitting an all time high of $217 trillion, ro 325% of world GDP. Of this increase, the IIF said that China accounted for the “lion’s share” and while China’s relentless debt-funded stimulus continues to be ignored by markets, one other organization that begins with I and ends with F has also noticed that China has a big problem.
As the IMF recently wrote in its IMFDirect blog, China urgently needs to tackle its corporate-debt problem before it
becomes a major drag on growth in the world’s No. 2 economy. Corporate debt has reached very high levels and continues to grow.
The International Monetary Fund then lays out at the dimensions of the problem:
From 2009 to 2015, credit grew very rapidly by 20 percent on average per year, much more than growth in nominal gross domestic product. What’s more, the ratio of non-financial private credit to GDP rose from around 150 percent to more than 200 percent, or about 20-25 percentage points higher than the historical trend. Such a “credit gap” is comparable to those in countries that experienced painful deleveraging, such as Spain, Thailand, and Japan.
It then combines the four nations debt/GDP in one chart, and shows the one chart that keeps it up at night.
The chart above make it obvious that unless something changes, and fast, the biggest growth dynamo behind global growth over the past decade – remember, as Kyle Bass so conveniently reminded us, China’s banking system has over $30 trillion in financial assets, debt asied – is about to short circuit.
Why the unprecedented debt growth? Simple: this corporate credit boom reflected the government efforts to stimulate the economy in the wake of the global financial crisis, largely through lending for infrastructure and real estate. The outcome: overbuilding and a severe overhang of unsold properties, especially in lower-tier cities, along with excess capacity in related industries such as steel, cement and coal. The combination of heavy borrowing and falling profits led to excessive debt loads. The problem has been worst among state-owned enterprises that benefit from preferential access to financing and implicit government guarantees, which lower the cost of borrowing.
The IMF then proposes several solutions: First, the government should make a high-level decision to stop financing weak companies, strengthen corporate governance, mitigate social costs and accept likely slower growth in the near term. It needs buy-in at every level—state-owned enterprises, local governments, and financial supervisors. Here are the other steps China’s government can take:
- Triage: Identify companies in financial difficulty and distinguish between those that should be restructured and those “zombie” companies that have no hope of survival and that should be allowed to exit. Because of the existing links between state-owned banks and corporations, a new agency could be created to perform this role.
- Recognize losses: Require banks to recognize and manage impaired assets. So-called shadow banks—trust, securities and asset-management companies—should also be forced to recognize losses.
- Share the burden: Allocate losses among banks, corporates, investors and, if necessary, the government.
- Harden budget constraints—especially on state owned enterprises—by improving corporate governance and removing implicit guarantees to prevent further misallocation of credit and losses.
It then adds that, for now, “risks appear manageable” but only if the problem is addressed promptly. And this is where the IMF suffers from a tremendous cognitive disconnect, when it says that “indeed, it is encouraging that the government has recognized the problem and is taking action to address it.”
Alas, that is not true, because while the government has indeed recognized the problem, it sternly refuses to address it, and instead just last year injected a record amount of debt in the system, even as total debt/GDP in China has now risen to 300%, according to the IIF.
The same lack of willingness to address any of China’s lingering structural problems can be noted in most other aspects of its financial system: from overhauling insolvent enterprises and failing to recognize the true extent of NPLs (the recent overtures in debt-for-equity are, sadly, far too modest to make any impact), to implementing broad bankruptcy reform (over fears of millions of workers losing their jobs in zombie enterprises), to the biggest elephant in the room: China’s currency woes, which instead of being “internationalized” is being increasingly pressured by the PBOC to trade at a given level due to concerns of soaring capital outflows limited by China’s reserve base.
It remains to be seen just when the chart that keeps the IMF up at night will lead to nightmares for others; for now, however, everyone is blissfully ignoring what may be the biggest problem in the world.