China’s Debt Dilemma: Deleveraging While Generating Growth


Long-Term Outlook: Structural Reform

Looking at China as a whole, alarmist rhetoric around the country’s short-term debt outlook overstates the system’s vulnerabilities, and the coming property correction is mostly an issue for real production rather than the financial system. That means that while there are likely to be defaults and a rise in nonperforming loans—legitimate concerns for investors in China—it is difficult to see how the situation could deteriorate so much that it would lead to a systemic financial crisis and derail the economy.

Many bears on China retort that even if the current situation is manageable, it is just a matter of time until China hits its debt constraint. Some analysts argue that the only way China can avoid a financial crisis is for growth to collapse to the low single digits.104 Similarly, the Fitch Ratings’ Report that has generated much of the alarm about China’s debt warns that “the longer that credit outpaces GDP, the greater the longer-term challenges.”105 The argument goes that since the financial crisis, the only thing that has kept growth so high in China is the even faster growth of credit. This framework indicates that, so long as rapid growth remains the government’s priority, leverage must continue rising until there is a crisis.

To the extent that growth truly has become dependent on credit-fueled investment, these analysts are right. However, one need not be so pessimistic about how quickly the economy can wean itself off credit while still generating growth.

Using Credit Productively

The more pessimistic narrative misunderstands how credit is being used in China. Much of the credit surge has been financing rising prices for property and other assets, but such increases are not included in calculating GDP growth. If these asset price increases are sustainable, however, current concerns over the debt buildup are not really an issue.

Here, the difference between fixed asset investment (FAI) and gross fixed capital formation (GFCF) is key. Both concepts are measures of investment, but FAI measures investment in physical assets, including land, while GFCF measures investment in new equipment and structures, excluding the value of land. Further, while GFCF feeds directly into GDP, only a portion of FAI shows up in GDP accounts.

For some time, the distinction between the two concepts did not matter in interpreting economic trends because the two measures moved in lockstep, reaching 35 percent of GDP by 2003. Since then, however, the two have diverged, and GFCF now stands at around 45 percent of GDP while the share of FAI has jumped to over 70 percent (see figure 17). According to Goldman Sachs, fully two-thirds of this divergence can be attributed to growing differences in asset prices, particularly the increasing value of land.106

Overall credit levels have increased in line with the rapid growth in FAI rather than the more modest growth in GFCF. Given that the major distinction between the two measures of investment is the inclusion of land-related transactions, this suggests that such transactions account for an increasingly large share of credit, which is not surprising given the fivefold increase in the price of land over the past decade. Since these land transactions do not contribute to GDP, and much of the recent credit growth relates to such transactions, this explains much of the decline in the growth impact of credit.

Since 2008, a lot of credit has been channeled into investment in assets that are not accounted for in GDP. While some of this was wasted on speculative real estate projects, the bulk of it was used productively and unlocked real value.

As such, much of the recent surge in China’s credit-to-GDP ratio can be thought of as financial deepening as China moves toward more market-based asset values. Once those values are established, land price growth and the amount of credit being channeled to these uses will level off. This will lead to a gradual shift in the allocation of credit back toward growth-enhancing GFCF investment and to a rebound in the growth impact of credit, allowing over 7 percent growth to continue even as credit slows.

Ways to Unlock Productivity Gains

Another reason to be optimistic about China’s ability to curb credit while generating growth is its potential to ratchet up productivity through structural reforms. Some observers believe that there is a trade-off between near-term growth objectives and implementing reforms. However, this is a false dichotomy. While some reforms may be contradictory to growth, most are complementary.

China’s run of more than 10 percent annual growth since 2003 was driven by growth in labor, capital, and productivity. China has exhausted its demographic dividend and is now seeing its returns on investment decline. Moreover, while increases in China’s total factor productivity have been well above the international norm, coming partly from the transfer of workers from agriculture to more productive industrial jobs, these gains have fallen in recent years.

Even so, there are still significant gains to be realized from the more efficient use of labor and other resources. The challenge for Beijing is increasing productivity again so the economy can grow at a sustainable rate of over 7 percent in the coming decade without relying on ever-increasing debt.

Reforms that improve the efficiency of the urbanization process would help generate some of the needed gains. Productivity increases from urbanization have been declining in recent years due to waste from the excessive conversion of agricultural land for urban use and policies preventing China from fully reaping the benefits that come from concentrating workers and activities in specific areas. The consequence has been urban sprawl, potential property bubbles, and “ghost cities.” The gains from migration have also declined because China’s unique residency restrictions inhibit workers from relocating to the largest cities that generate the most productive jobs.107

A more efficient urbanization process would promote denser settlement patterns and allow market forces to shape growth in China’s megacities rather than artificially spreading out development.108 This would help capture the large differences between the productivity of workers in rural areas and their urban counterparts. Although China has been urbanizing rapidly, only 52 percent of people currently live in cities, which suggests that potential productivity gains are still substantial.109 

Allowing the private sector to play a more prominent role could also unlock massive gains in productivity. This has been a recurring theme, but the case for empowering the private sector has never been as strong as it is now. Productivity differences between private and state firms did not matter as much when returns on assets were rising for both groups and differences were narrowing in the years before the financial crisis. Both cohorts took a hit during the crisis, but rates of return for private firms have since rebounded sharply and are now around 11 percent compared with state firms, whose rates have fallen to 4–5 percent (see figure 6 above). This difference illustrates the potential productivity and growth benefits that would come from a rebalancing in favor of the private sector.

Reforms that simply call for leveling the playing field between state and private firms will not increase productivity significantly. Many of the reforms undertaken so far, including simplifying investment procedures and liberalizing capital movements, will help. But bolder policy actions—such as getting the state out of a range of commercial activities and opening up other areas, especially services, for private entry by both domestic and foreign firms—must be part of the productivity-boosting agenda. Unless Beijing shows a willingness to tackle major structural distortions that warp incentives to favor state enterprises, the economy cannot realize the efficiency increases it needs for rapid and sustained growth.

Reforms to curb the privileged position of SOEs will also address many of the issues with China’s financial markets. Most SOEs benefit from explicit or implicit government guarantees that give them and their creditors few incentives to limit their leverage. This has made SOEs the primary bad actors driving the excessive accumulation of corporate debt, and curbing them will free up capital for more productive small and medium private enterprises.

Finally, productivity could be enhanced by reconsidering where investments are made. Currently, investments in the interior provinces, especially the far west, have been given priority because of equity concerns because household incomes are much lower in the interior relative to the coastal provinces. This initiative has encouraged overly elaborate infrastructure projects and the construction of ghost towns that were initially justified by the need to combat regional inequality. Although these projects have had some success in reducing regional inequality, they are a costly approach to the issue. The economic returns on most projects in the far west are quite low while the direct costs are high. There is more to be gained by facilitating migration from the less productive regions to those that are more productive coupled with altering the composition of investment in favor of social and environmental services.

Whether China will implement the necessary reforms to improve the efficiency of the urbanization process, allow the private sector to play a more prominent role, and rebalance its regional investment strategies remains to be seen. The Third Plenum held in November 2013 laid out a comprehensive plan for reforming the economy over the coming five years, calling for the market to play a “leading role” in the economy and listing a wide range of reforms meant to unify rural and urban markets and facilitate urbanization. Should these productivity-enhancing reforms be rigorously implemented, they could boost China’s growth rate by 1–2 percentage points following a year or two of pain from the property correction.


China’s credit boom fundamentally differs from those that preceded it. The initial debt surge was the result of a deliberate, state-driven stimulus program undertaken in response to the global financial crisis. Although it was clearly overdone, it succeeded in staving off an imminent economic collapse.

In the aftermath of the stimulus, however, many of the dysfunctions of China’s economy have come to be reflected in the financial system. The origins of China’s problems lie in its broken fiscal system, which has generated ever-growing and opaque local government debts. The risks posed by that debt are difficult to track. The privileges of state-owned enterprises have encouraged irresponsible behavior, generating excess capacity and a mountain of corporate debt. And distorted incentives have spurred the growth of both shadow banking and a property boom.

These are all serious challenges that are causing a costly hemorrhaging of financial resources. Banks will continue to be responsible for more nonperforming loans, and defaults in the bond and shadow-banking markets will become more frequent. The government will periodically need to step in to bail out companies that are considered too big to fail, both public and private, and it may even be forced to engage in another costly bank cleanup like that of the early 2000s. The process will be messy and costly, and it will not reflect anyone’s ideal outcome. But China’s financial troubles do not guarantee a downturn similar to what happened during the Asian financial crisis or the prolonged economic slump that has affected Europe and Japan.

Of course, though it may avoid a complete meltdown, China does need to enact serious financial, fiscal, and economic reforms to prevent the country’s current problems from recurring in the future. With each episode of financial turmoil, the country hemorrhages resources and loses some of its capacity to absorb such losses. Eventually, its fiscal space will run out.

Marginal financial engineering will not be sufficient to address the financial system’s issues. Instead, tackling them will require relieving the financial pressures created by the dysfunctional fiscal system in tandem with structural reforms to enhance productivity and better align incentives in the real economy.

Without a revamped fiscal system, the government remains excessively dependent on bank credit for public spending. In such a context, financial reforms like interest rate liberalization will do little to inhibit the unsustainable accumulation of local government debts. Instead, the budget must be strengthened and government revenues increased. This will require raising personal income taxes, establishing a new property tax regime, and developing a more equitable system of revenue sharing between the central and local governments. It would also be wise to allow local governments to borrow more directly from banks and capital markets rather than encouraging an opaque LGFV approach currently necessitated by the “ban” on local government debt. Shifting the responsibility for funding public services from the banks and LGFVs back to the fiscal system would foster greater transparency and accountability while also inhibiting corruption.

Before long, China will also have to begin deleveraging, but this is rarely achieved by reducing the absolute amount of debt in a country, or even by halting its growth. Rather, the key to deleveraging will be enabling GDP to grow more rapidly than credit. And that will only be possible if China engages in serious structural reforms to capitalize on areas of untapped productivity gains. Three areas of reform stand out: allowing for a more natural and efficient urbanization process; allowing greater private entry to sectors monopolized by the state and getting the state out of some sectors altogether; and realigning regional investment patterns with underlying economic fundamentals.

The Third Plenum reform package shows that the leadership understands the need for such actions. Although there are real questions about the government’s ability to overcome vested interests, steps taken thus far suggest that Beijing is committed to unlocking rapid growth well before the end of this decade.

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