Since the financial crisis, China has experienced a rapid rate of credit growth, which has been integral to the country’s ability to sustain high gross domestic product (GDP) growth rates. It has also stressed China’s banking system. We believe that China’s credit growth rate is unsustainable over the long term and that any slowdown in credit growth could have negative implications for both Chinese and global economic growth.
Credit growth is an important driver of economic growth. Borrowing enables businesses to increase capacity and consumers to purchase big ticket items. These purchases and investments drive corporate profits and employment, which drive further investment and consumption, creating a virtuous cycle.
The Rise of Credit in China
Before the 2008 financial crisis, developed market countries accounted for much of the world’s newly created credit. Post-crisis, China has accounted for a significant and increasing portion of credit creation in the 20 largest economies (the G20). In 2016, for example, over half of all newly created private non-financial credit in the G20 occurred in China.
China has also maintained one of the world’s highest sustained GDP growth rates for nearly two decades – close to 10% annually – although it has slowed in recent years. China’s commitment to maintaining rapid GDP growth has been met largely through debt-funded fixed-asset investments in areas such as infrastructure and factories. In the last five years, the return on these investments has been lower than it was in the past. As a result, achieving the same GDP growth target has required increasing levels of investment and debt, ultimately resulting in an accelerating debt-to-GDP ratio.
Potential Signs of Trouble
China’s private non-financial debt-to-GDP ratio is high both on an absolute basis and relative to its own medium-term history. Exhibit 2 compares China’s current credit expansion with three previous credit booms that ended in crisis or protracted slowdown. All four cycles consist of a rapid credit expansion to levels close to 200% of GDP.
At the same time that China’s debt growth has accelerated, the size of the Chinese banking system has ballooned. Banking assets are currently $33 trillion USD, or approximately three times GDP. Compare this to the United States, where the total assets in the banking system amount to less than GDP. China has both significantly larger banking assets and less GDP than the United States.
Rapid credit growth can lead to unproductive lending and bad loans. In 2016, the International Monetary Fund estimated that 15% of Chinese borrowers do not generate sufficient cash flow to cover interest expense.1 To the extent that borrowers default on these loans, it will reduce bank lending capacity and make it difficult to maintain rapid credit growth.
Global growth is substantially supported by Chinese credit growth. Both the level of Chinese debt relative to GDP and the rate of acceleration of the debt-to-GDP ratio suggest that the country’s credit growth may be unsustainable. Further, this credit growth appears to be stressing the banking system, creating a potential catalyst for a significant slowdown in credit creation. If this slowdown occurs, it could have a meaningful impact on global credit creation and economic growth. Of course the credit growth could continue and, even if it does slow, it is possible that China will find other engines of economic growth – but we don’t see any obvious candidates on the horizon.
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1Source: “IMF Working Paper: Resolving China’s Corporate Debt Problem,” International Monetary Fund, October 2016.