long as they support economic growth (via local party-bureaucracy’s influence on the banking system, which is almost entirely state-controlled). Further, state-level party and bureaucracy seem to have an incentive to prioritize economic growth (over other socioeconomic objectives) because their professional upward mobility seems contingent upon delivering output growth and employment generation in their territory. Similarly, provincial statistical offices have an incentive to show that the targets are met, which is said to be a reason for the overestimation of provincial output growth and an underestimation of unemployment rates.
Given the incentive structure, and political legitimacy derived from generating growth and employment, the aftermath of the financial crisis posed a major challenge to Chinese policymakers. China, therefore, undertook massive fiscal and monetary stimulus measures — perhaps the largest among G20 countries — to prop up domestic demand in the face of collapse of the external markets [need to quantify these measures as GDP%]. Most of these resources went into infrastructure and urban housing. Urbanization therefore became a policy goal it itself.4 Though such a policy did not revive economic growth to pre-financial crisis level, it perhaps prevented a collapse of domestic demand and employment. Investment levels were maintained (or even surpassed the pre-crisis levels), and the best evidence of it is the rise in debt/GDP ratio from about 160% of GDP before the crisis to the current level of 230–260% of GDP (Figure 3).
Figure 3:China’s debt–GDP ratio.
Source: Goldman Sachs: Walled in: China’s Great Dillemma (2016).
Composition of Debt
Incremental debt largely accrued to the private corporate sector (PCS), which is mostly associated with provincial governments, which use local government financial vehicles (LGFVs) to draw credit from the banking system to promote local infrastructure and housing investment. This is evident from an IMF study:
“A significant part of corporate borrowing in reality financed off-budget fiscal spending. Off-budget local government borrowing has increased substantially since the GFC. It was undertaken by LGFVs; as local governments were not allowed to borrow explicitly. The loans typically financed infrastructure projects and repayment was covered by future disbursements from local governments (e.g., in a form of service fees). The ‘augmented’ deficit, which LGFV spending given the fiscal nature of such operations, thus jumped from the average of around 4 percent of GDP before 2008 to about 10 percent in 2015” (IMF, 2014; Maliszewski et al., 2016: 20).
Figure 4:Rising share of shadow banking in China’s credit growth.
Source: Maliszewski et al. (2016).
Another reason for the rapid rise in debt–GDP ratio is the growth in shadow banking institutions, often sponsored by regular financial institutions to circumvent strict regulation and offer higher rates of return to its savers (Figure 4).
The above-mentioned debt ratio may be an underestimate as private sector firms have substantial overseas borrowings undertaken by their foreign subsidiaries. Such borrowings do not get registered as China’s external debt as they is recorded by the residency of the issuing entity, not by their nationality. If such borrowing is used to finance capital expenditure in China, then it could cause currency and maturity mismatch, increasing the cost of such borrowing and leading to a rise of financial fragility. Further, in the event of rising international interest rates (as is the case now with the Fed raising the rates) such a hidden debt could add to the external instability (Shin and Zhao, 2013) (Figure 5).
China has also sought to rebalance the economy away from manufacturing to services, and away from investment-led economy to consumption-driven economy (Figure 6). On the face of it, looking at the official numbers, there is a change in the desired direction, in particular in the rise of financial services. But how much of it represents expansion of genuine financial services and how much of it is statistical illusion caused by over blown shadow banking seem to be open to question.
Figure 5:International debt securities outstanding for non-financial corporate by nationality and by residence.
Source: Shin and Zhao (2013).
Figure 6:Rising share of services in China’s GDP.
Source: Steve Johnson, “Old economy focus ‘understates’ Chinese growth”, FT, December 9, 2015.
That China has made excessive investment in physical infrastructure and in urban housing — relative to effective demand — is a widely accepted fact (based on innumerable news reports about ‘ghost’ towns, unused roads, and bridges). Rising credit and debt growth (as GDP%) after the financial crisis and decelerating outgrowth has resulted in rising incremental capital output ratios (ICORs), or credit intensity of output.
Rising Real Estate Prices
While the rate of investment in real estate seems to be decelerating lately, property prices seem to continue to rise (Figure 7).
The usual official defence of such an investment strategy is two-fold: (1) it is wise to build infrastructure ahead of demand to avoid short-run bottlenecks (as exemplified by Indian experience), as recommended in development literature (à la Arthur Lewis); (2) as capital stock per head in China is way below that in the developed economies, China has to invest more, and not less, quickly if it is to graduate to the status of a developed economy.
But there has been a growing concern about China’s debt sustainability, and the potential instability that could follow. There are apprehensions that the magnitude of debt could, if it crosses the tipping point, potentially lead to Japanese-style debt deflation, or a real estate bubble burst.
Figure 7:Rising real estate prices.
Source: The Economist (2016).
There are other concerns about potential capital outflows on account of global financial instability or domestic political consideration (in particular the on-going anti-corruption drive) that could lead to capital flight (as evident from depreciation of yuan, or due to capital market gyrations last year).
Given China’s huge foreign exchange (forex) reserves, prima facie, external debt crisis seems to be ruled out. Moreover, since the majority of China’s private sector debt is in domestic currency, it is argued that the Chinese government can reschedule the debt without destabilizing its external sector. But the question of whether China can avoid getting into Japanese-style debt deflation is hard to speculate. Similarly, the Chinese central government seems unable to regulate housing investment adequately as much of it seems to be financed by shadow banking driven by interests at the provincial
