China’s Hidden Debt Risk

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In the last 200 years, there have been more than 250 casesof sovereign-debt default, and 68 cases of domestic-debt default. None of thesewas an isolated incident. Indeed, such defaults – combined with factors likelarge current-account or fiscal deficits, overvalued currencies, highpublic-sector debt, and insufficient foreign-exchange reserves – have alwaystriggered financial crises, from the Mexican peso crisis in 1994 to the Russianruble crisis in 1998 to the American subprime mortgage crisis in 2008.
Since China’s era of reform and opening up began, thecountry has experienced three instances of large-scale public-finance problems.In the late 1970’s, the country faced a debilitating fiscal deficit. In the 1990’s, itscorporate sector was plagued by “triangular debts” (when a manufacturer thathas not been paid for its product is unable to pay its suppliers, which in turnstruggle to pay their suppliers). Later that decade, financial institutionswere burdened by bad debts generated by state-owned enterprises.
Now China is experiencing a fourth instance of elevateddebt risk, this time characterized by high levels of accumulatedlocal-government and corporate debt. To be sure, China’s national balancesheet, which boasts positive net assets, has garnered significant attention inrecent years. But, in order to assess China’s financial risk accurately,policymakers and economists must consider the risks that lie in the country’sasset structure – and the liabilities that are not included on its balancesheet.
The current problems are rooted in the government’sresponse to the 2008 global financial crisis. The first round of fiscalstimulus, supported by credit easing, led local governments and the financialsector to increase their leverage ratios. As a result, by 2010, China’s overallleverage ratio had risen by 30%.
In 2011, local-government debt totaled ¥10.7 trillion ($1.7trillion), with only 54 of more than 2,500 county governments debt-free. Debtsincurred by local government investment vehicles (LGIVs) totaled almost ¥5trillion – 46.4% of overall debt.
At the end of 2011, China’s Treasury-bond debt stood at¥7.2 trillion, and its ratio of foreign debt to foreign-exchange reservesreached 21.8%, having grown by 27% since 2010. But, while this represents anincrease for China, it remains well below the widely recognized dangerthreshold of 100%.
Likewise, China’s debt/GDP ratio is rising, though itremains within the “safe” boundary of 60% – and is considerably lower than theratio in most developed economies. At the end of 2011, China’scentral-government debt amounted to 16.5% of GDP, and overall government debttotaled ¥18 trillion, or 38% of GDP.
Judging from its balance sheet, then, the Chinesegovernment has a relatively large stock of net assets and a low debt ratio, andthus seems to be in a solid position to manage its liabilities. Indeed,according to China’s Academyof Social Sciences, China’s sovereign net assets increased every yearfrom 2000 to 2010, reaching ¥69.6 trillion – enough to cover the government’sobligations.
But positive net assets are not sufficient to eliminatefinancial risk, which also depends on asset structure (the liquidity of assetsand the alignment of maturities of assets and liabilities). If a largeproportion of a country’s assets cannot be liquidated easily, or would be greatly depreciatedby a large-scale sell-off, the fact that assets exceed liabilities would notrule out the possibility of debt default.
In China, this proportion of fixed, illiquid assets exceeds90%. Resource assets account for roughly 50% of total government assets, withoperating assets amounting to 39% and administrative (or non-operating) assetscomprising another 6%.
The latter two are difficult to liquidate. And, given thatresource assets are scarce and non-renewable, the traditional practice ofauctioning and leasing land to keep the fiscal deficit under control isunsustainable – especially at a time when external shocks or a domesticeconomic downturn could easily trigger a short-term solvency crisis or debtdefault. While fiscal revenues are on the rise, they account for only about 6%of China’s total assets – and their growth rate is slowing.
China faces additional debt risks from contingentliabilities and inter-departmental risk conversion, especially in the form of implicitguarantees on debts incurred by local governments and state-owned enterprises.Indeed, such guarantees constitute the most significant medium- and long-termfinancial risks to China.
In recent months, there has been a surge in LGIV bondissuance, aimed at supporting local governments’ efforts to stabilize economicgrowth through stimulus-style investment projects. But the implicit guaranteeson these bonds – as well as on existing bank loans – amount to hiddenextra-budgetary liabilities for the central government.
Local governments have also accumulated massive amounts ofnon-explicit debt through arrears,credits, and guarantees.Once this debt’s cumulative risk exceeds a local government’s financialcapacity, the central government is forced to assume responsibility for servicing it, directlyendangering its own financial capacity.
At the same time, China’s corporate sector reliesexcessively on debt financing, rather than equity. China’s non-financialcorporate debt accounts for roughly 62% of total debt – 30-40% higher than inother countries. According to GK Dragonomics, China’s total corporate debtamounted to 108% of GDP in 2011, and reached a 15-year high of 122% of GDP in2012.
Many of these heavily indebted enterprises are state-owned,and have borrowed from state-controlled banks. The implicit guarantees on thisdebt, too, suggest that the government’s liabilities are much higher than itsbalance sheet indicates.
China is not too big to fail. In a fragile economicenvironment, policymakers cannot afford to allow the size of China’s balancesheet to distract them from the underlying structural risks and contingentliabilities that threaten its financial stability.

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关键词：Hidden China DEBT HINA Risk defaults mortgage factors China

In the last 200 years, there have been more than 250 casesof sovereign-debt default, and 68 cases of domestic-debt default. None of thesewas an isolated incident. Indeed, such defaults – combined with factors likelarge current-account or fiscal deficits, overvalued currencies, highpublic-sector debt, and insufficient foreign-exchange reserves – have alwaystriggered financial crises, from the Mexican peso crisis in 1994 to the Russianruble crisis in 1998 to the American subprime mortgage crisis in 2008.


Since China’s era of reform and opening up began, thecountry has experienced three instances of large-scale public-finance problems.In the late 1970’s, the country faced a debilitating fiscal deficit. In the 1990’s, itscorporate sector was plagued by “triangular debts” (when a manufacturer thathas not been paid for its product is unable to pay its suppliers, which in turnstruggle to pay their suppliers). Later that decade, financial institutionswere burdened by bad debts generated by state-owned enterprises.



Now China is experiencing a fourth instance ofelevated debt risk, this time characterized by high levels of accumulatedlocal-government and corporate debt.
The current problems are rooted in the government’sresponse to the 2008 global financial crisis. The first round of fiscalstimulus, supported by credit easing, led local governments and the financialsector to increase their leverage ratios.
Debts incurred bylocal government investment vehicles (LGIVs) totaled almost ¥5 trillion – 46.4%of overall debt.


But positive net assets are not sufficient toeliminate financial risk, which also depends on asset structure (the liquidityof assets and the alignment of maturities of assets and liabilities). If alarge proportion of a country’s assets cannot be liquidated easily, or would be greatly depreciatedby a large-scale sell-off, the fact that assets exceed liabilities would notrule out the possibility of debt default.In China, this proportion of fixed, illiquid assets exceeds90%. Resource assets account for roughly 50% of total government assets, withoperating assets amounting to 39% and administrative (or non-operating) assetscomprising another 6%.
The latter two are difficult to liquidate.


China faces additional debt risks from contingentliabilities and inter-departmental risk conversion, especially in the form of implicitguarantees on debts incurred by local governments and state-owned enterprises.
At the same time, China’s corporate sector reliesexcessively on debt financing, rather than equity。
Many of these heavily indebted enterprises arestate-owned, and have borrowed from state-controlled banks. The implicitguarantees on this debt, too, suggest that the government’s liabilities aremuch higher than its balance sheet indicates.