“International experience suggests that China’s current credit trajectory is dangerous with increasing risks of disruptive adjustment and/or a marked growth slowdown,” the IMF wrote in its most recent China report.
While the IMF revised China’s growth average to 6.4% from last year’s 6% estimate, it warned that total non-financial sector debt, which includes household, corporate and government debt, is expected to continue to rise strongly, reaching almost 300% of GDP by 2022, up from 242% last year.
China’s average real GDP would have been around 5.5% over the last five years in the absence of excessive credit growth, the IMF added.
Revised debt-to-GDP ratio (%, vs 2016 estimate)
Source: International Monetary Fund
The IMF identified 43 cases of credit booms in which the credit-to-GDP increased by more than 30 percentage points over a five-year period. Among these, only five cases ended without a major growth slowdown or a financial crisis afterward.
In addition, all credit booms that began when the ratios were above 100% – as in China’s case – ended badly.
Credit in China is also inefficiently used, according to the report. Debt in the industrial sector, state-owned enterprises and firms in the Northeast region is significantly higher than their output.
Inefficient credit
Source: International Monetary Fund
Besides debt being used inefficiently, the complex funding structures and sizable, opaque off-balance sheet investments by banks suggest that a deleveraging process in the financial sector could be bumpy.
Banks have relied on increasingly complex funding structures, extending beyond deposit funding to interbank markets and wealth management products, and via complex and interlinked networks of entities.
These banks often finance illiquid long-term investments by rolling over short-term funding or pooling investment funds.
In addition, debt is fuelled by domestic wealth management products (WMPs), which have $4.3trn (RMB 29trn) in assets — about three times the size of China’s total mutual fund assets.
“WMPs have become an important source of funding for Chinese borrowers, such as local government financing vehicles, corporates in industries with overcapacity issues, property developers, and other corporates facing funding constraints,” noted ANZ Bank in a research report on China.
Can buffers help?
The IMF highlighted specific factors that can help mitigate near-term risks of a disruptive adjustment and buy time to address risks.
These factors are high savings, strong corporate balance sheets, current account surplus, small external debt and various policy buffers. However, these factors do not eliminate the eventual crisis risk, and if the risk is left unaddressed, would just make the credit boom larger and longer, the report noted.
“Decisive policy action is thus needed to deflate the credit boom smoothly,” the IMF said.
Among the suggested policy actions were “closing loopholes for regulatory arbitrage, reining in leverage and increasing transparency of non-bank financial institutions and wealth management products”.
