Thursday, May 25, 2017

China's Bill Will Have To Be Paid

A Moody's downgrade makes clear there's no easy way out of its debt problems.

By Michael Schuman
The Bloomberg View
May 25, 2017

On Tuesday night, Moody’s Corp. downgraded China’s sovereign credit rating for the first time in 28 years. In doing so, the rating agency is acknowledging the dragon in the room: China will have to pay the price for its epic debt binge, whatever policymakers do from here.

The burning question in China these days is whether the government is serious about tackling the debt pile that's exploded since the global financial crisis. Total outstanding credit grew to around 260 percent of GDP at the end of last year, from 160 percent in 2008 -- one of the biggest and fastest expansions ever. Officials say they're keenly aware of the need to deleverage, and there's evidence that recent efforts to deal with the problem are starting to have an impact. What's uncertain is whether the government has the will to push ahead with reforms even as companies start to default and the economy slows.

With its decision, Moody's essentially recognized that the task of resolving China's debt problems is going to bear more and more heavily on the state and the economy. “The downgrade,” the agency explained, "reflects Moody's expectation that China's financial strength will erode somewhat over the coming years, with economy-wide debt continuing to rise as potential growth slows.”

The downgrade was slight, and China remains well within investment grade. Still, Moody’s concerns should wake up those investors who have decided, based on the apparent calm in Chinese stock and currency markets, that the country isn't experiencing financial strain. What's happening today may not look like the meltdowns suffered by South Korea or Indonesia in the 1990s. But that might be only because the state retains so much more control in China. If officials hadn’t stepped in last year to curtail escalating outflows of capital, the picture would likely have looked much grimmer.

This “crisis with Chinese characteristics” features all of the seeds of a much more serious downturn: still-rising debt, unrecognized bad loans and a government paying lip service to the severity of the problem. Brandon Emmerich of Granite Peak Advisory noted in a recent study that more and more new debt is being used to pay off old debt, and “a subset of zombie issuers borrowed to avoid default.” As he explains, “even as Chinese corporate bond yields have rebounded (in 2017) and issuance stalled, the proportion of bond volume issued to pay off old debt reached an all-time high -- not the behavior of healthy firms taking advantage of a low-yield environment.”

Efforts to curtail credit will thus inflict serious pain on corporate China. And given that the economy remains largely dependent on debt for growth, deleveraging will also make it harder for such firms to expand and service their debt. The one-two punch could push more companies toward default, punishing bank balance sheets.

What's more, if Beijing policymakers respond by ramping up credit again, all they’ll do is delay the inevitable. Larger dollops of debt simply allow zombie companies to stay alive longer and add to the debt burden on the economy.

Sooner or later, the government is going to have to bail out local governments and state-owned enterprises, and recapitalize the banks. The only question is how expensive repairing the financial sector will be for taxpayers once Chinese leaders realize the game is up. Looking at past banking crises, the tab could prove huge. South Korea’s cleanup after the 1997 crisis cost more than 30 percent of gross domestic product. Applying that to China suggests the cost would reach some $3.5 trillion.

Chinese leaders might be able to keep the final bill down if they take steps now to eradicate zombie firms, strengthen bank balance sheets and allow the market more say in the allocation of capital. Moody's, however, was dubious: “We do not think that the reform effort will have sufficient impact, sufficiently quickly, to contain the erosion of credit strength associated with the combination of rising economy-wide leverage and slower growth.”

There will be those who dismiss all this as a fantasy conjured by anti-China bias or an inability to grasp the wonders of the Chinese economic system. But the dangers escalating debt present to the Chinese economy are a simple matter of mathematics. Insisting China is somehow immune to such logic is the biggest risk of all.

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