Balance sheet doesn't provide simple explanation

Difficult measures need to be taken soon to prevent current situation from escalating into something much more serious

China's nonfinancial debt, now estimated to have risen to about 250 percent of GDP, is one of the most talked-about economic phenomena on Earth. Doomsayers see it as the harbinger of imminent economic collapse. Optimists say it's nowhere as bad a problem as made out because debtors have assets, China has a high savings rate and doesn't owe much to foreign creditors. Both are wrong.

Instead, we have to understand that we can't look at China's assets and liabilities the same way we might look at those of a company. We also have to recognize that even creditor countries such as China that borrow in their own currency cannot sustain rising debt when repayment capacity is deteriorating.

It is also imperative to focus not so much on the asset side of China's debt balance sheet but on the liability side, and especially the funding structure of the liabilities. Without a major change in policy fairly soon, China's debt will lead to instability within the next 2-3 years and a protracted hit to economic growth.

After a period of credit policy restraint from 2012 to 2014, there was a remarkable U-turn in 2015. The new commitment to 6.5 percent annual growth - as provided for by the 13th Five Year Plan (2016-20) - took the focus away from economic reform and underscored a new borrowing surge by local governments, including local government finance vehicles, state-owned enterprises and new outlets such as public-private partnerships, development funds and policy bank programs. There was also a strong expansion in the balance sheets of banks, and nonbanking financial intermediaries, including trusts, insurance and securities companies, pension and wealth management product providers and other finance companies.

Nonbanking intermediaries and providers of new financial products that raise deposits to fund loans accounted for barely 20 percent of the total banking system assets of around 250 percent of GDP in 2008-09. Now, though, they account for 35 percent of assets and total nearly 450 percent of GDP.

This gives rise to four crucial observations. First, the strong acceleration in credit creation hasn't been an accident. It bears the hallmark of financial liberalization and clear top-down policies designed to support economic growth.

Second, because direct banking exposure to borrowers, and that of China's major four banks in particular, has declined relatively speaking, the focus necessarily falls on the intermediaries that generate both deposits and loans. Many, but not all, of these fall within the so-called shadow banking sector.

Third, these institutions do not respond as easily to control as, for example banks do to lending guidance. They also depend much more heavily than banks on short-term (overnight to one month) and volatile forms of deposits.

In its October 2016 Global Financial Stability Report, the International Monetary Fund estimated that wholesale funding of banking sector lending - for example in the interbank and repurchase markets - had risen 10 to 30 percent since 2010, and was a much larger issue for smaller banks and the NBFI's.

Fourth, China's debt and banking system vulnerability is therefore not so much the surge in asset growth and the rise in bad assets and nonperforming loans, important as these are. On the asset side, according to private estimates, nonperforming loans now account for perhaps 20 percent of banking sector assets. The government, PBoC and China's Banking Regulatory Commission are doubtless keenly aware of the problem, and they can freeze or mitigate the problem of bad loans and loss recognition for awhile by "evergreening" - that is, by rolling the problem into the future, or by creative accounting.

But it is much harder to hide or offset the problems on the liability side. If and when the providers of very short-term deposits want their money back, the PBoC can of course step in to fill the gap in the formal banking sector. Yet the central bank's liquidity does not extend to other players in the same way, and it would be hard to stop the contagion of illiquidity spreading from one institution to another, especially as one could imagine collateral values - for example property and land prices - falling, and a significant rise in capital outflows.

This is the way financial crises happen. The government will certainly be keen to prevent any financial instability. But the timeline for macroeconomic policies to switch toward lowering credit and economic growth - which would almost certainly raise unemployment - and rebalancing state and private sector asset ownership is shortening all the time. Without a change soon, China's debt will continue to expand, and by 2018-19 instability metrics will have risen further to dangerous levels.

The author is an Associate at Oxford University's China Centre and a senior independent economic adviser at UBS. The views do not necessarily reflect those of China Daily.

(China Daily Africa Weekly 11/25/2016 page9)