Most analysts agree that the rate of China's debt build up is cause for alarm. Some predict an imminent blow up in the form of a major financial crisis. Others predict a Japan-style series of 'lost decades' as the debt burden drags down economic growth.
Market forces do not operate in the usual way in China. Opting for a slow adjustment process does not mean that Beijing is simply sitting on the fence. This, in short, is deleveraging by stealth. The nature of China's debt rules out the likelihood of a systemic crisis, and the crux of the issue lies in the overall balance sheet. We make a debt distribution adjustment by combining the debt of the govenment, SOEs and local government funding vehicles to estimate the overall debt of the state. These adjustments do not change the total amount of debt, but the mix alters dramatically: corporate debt looks far less frightening from a default perspective. The implication is the central government still has room to absorb the current level of debt onto its balance sheet without triggering a crisis.
We identify four main reasons why the government's position is stronger than is assumed by those who are predicting a crash landing: 1) the state can make all the difference; 2) the overall balance sheet is healthy; 3) the level of external debt is low and that of domestic savings high; 4) and real estate, which is widely used as a form of collateral, has not yet collapsed.
Unlike many China sceptics, we believe policymakers are proactively seeking to contain financial risks by means of the following measures: 1) pooling the risks among different sectors, 2) stealth restructuring and controlled defaults, 3) increasing SOE efficiency without privatization and de-monopolization, 4) forcing financial deleveraging and strengthening regulatory coordination, 5) narrowing the credit gap with nominal GDP.
There has been no financial crisis or debt blow-up. Defaults have been allowed to rise in certain specific cases as healthy part of a more macro-prudential policy. Deleveraging by stealth continues.