Should China Deleverage? Yu Yongding, Project Syndicate, 29 June 2017

“China’s debts --especially corporate debts-- are a serious problem, and must be curbed. But China must balance that imperative with the more urgent need to maintain a growth rate more or less in line with potential, and prevent the economy from being tipped back into a debt-deflationary spiral. So far, China has managed to juggle these two imperatives”.

China’s mounting debt problem caused Moody’s to downgrade it’s sovereign rating. China’s overall debt-to-GDP ratio is not an outlier among emerging-market economies, and its levels of household and government debt are moderate, but its corporate debt-to-GDP ratio, at 170%, is the highest in the world. China’s corporate leverage (debt-to-equity) ratio is also very high, and rising. A high and rising debt-to-GDP ratio, which goes hand in hand with a high and rising leverage ratio, can lead to financial crisis through three channels. 1) The deterioration of the quality of financial institutions’ assets, and the decline in their price. With institutions forced by mark-to-market accounting to write off an equal amount of equity, the leverage ratio rises, leading to a further deterioration in asset quality and asset prices. 2) Refusal by investors, concerned about the rising leverage ratio, to roll over short-term debt. Money market might seize up, forcing banks to tighten credit and raise interest rates, weakening borrowers’ debt-service capacity. Defaults proliferate and nonperforming loans rises. 3) Driving banks unable to secure sufficient capital, into bankruptcy. The public could panic fueling a run on deposits and a collapse of the financial system. But none of these scenarios is a real risk for China in the foreseeable future. China is a country with gross savings of 48% of GDP. Loanable funds are abundant, and funding costs low. China’s debt consists of loans by state-owned banks to state-owned enterprises: depositors and investors are confident their assets carry a government guarantee. The government’s fiscal position is strong, and has $3 trillion in foreign-exchange reserves. China’s government could bail out banks in trouble, preventing contagious bankruptcies. Mitigating the debt risk further, China’s capital account remains largely closed, able to block capital flight. None of this is to say that China’s high level of corporate debt is not a cause for concern. But it does imply that deleveraging is no as urgent as many think, especially if China has another policy imperative to pursue --that could be undermined by rapid deleveraging--.

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Should China Deleverage? Yu Yongding, Project Syndicate, 29 June 2017


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