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Until Debt Do Us Part - Outside View by Nitin Gregory

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Until Debt Do Us Part
May 30, 2016

  • When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having being fairly and completely paid.
    - Adam Smith from The Wealth of Nations

Debt is a common funding source for many governments. When tax receipts fall short, debt is a great way to fund political agendas and even wars.

But sometimes the debt load becomes too high. Investors stop believing that the country can grow and repay its debt. Let us call this the 'debt limit'.

When investors lose faith, borrowing costs go up (e.g. Greek crisis 2010) or the currency devalues and debts denominated in foreign currency become very expensive (e.g. Asian crisis 1997).

Debt limits are subjective and decided by the investors. While the Greek government has faced rising borrowing costs during the crisis, a country like Japan with a staggering debt of 246% of GDP has negative interest rates!

Today, global debt has grown significantly. Between 2007 and 2014, the MGI (Mckinsey Global Institute) estimates that global debt has grown by $57 trillion (i.e. about three times US GDP!). About 36% of that increase has come from China.

Where is all this debt?

Total debt can be classified as household, corporate, and government debt. The total government debt for China is estimated to be around 40%. This is an underestimate - the government is a key economic player in the Chinese economy. The debt in the state-owned banks and enterprises (SOEs) are also essentially public debt.

Another key difference in the composition of China's debt is their shadow banking sector. This refers to entities that provide funding but are not a part of the regulatory framework. The loans in this sector are not defined, but are estimated as significant for analysis.

What did it fund?

Rapid debt increases are typically followed by the end of a bubble. This was the case in 2008 with the collapse of the real estate bubble in the USA. Similar episodes have occurred in Japan. Is there a bubble in the Chinese economy?

A large portion of the debt increase is related to the government stimulus after the great recession. This money has financed real-estate developers and many flagging state-owned enterprises. Overcapacity in some sectors including real estate has been identified.

What next?

Debt is nothing but borrowing against future growth. In the past, strong external demand and weak currencies have helped countries export and grow out of their debts. This scenario seems unlikely today.

In China around the late 90s, distressed bank loans were packaged and sold to four large asset management companies. These were 'bad' banks that held all the distressed assets freeing up the balance sheets of the regular banks. This allowed the regular banks to avoid a capital crunch.

These companies have resorted to different methods to deal with the bad loans. The methods include debt-for-equity swaps, extensions, and even selling off these loans on ecommerce sites! The bad banks are reporting a profit today and are looking to list on the Hong Kong exchange. This means they are looking to recapitalise.

These are signs that the bad banks are getting ready for another round of clean-up. Any stress in Chinese banking will be dealt with a mixture of government stimulus and packaging of 'bad loans'.

Financial engineering ('bad' banks) helps avoid economic shocks. However, the real test is in being able to force changes in state-owned enterprises and real estate firms. Unless the measures address overcapacity and profitability, the debt problem is only being postponed.

Rebalancing from an investment-lead model to a consumption-lead model is important. Restructuring SOEs, cooling the property sector, and providing social safety nets during the transition are integral if the rebalancing is to be successful.

This column is authored by Nitin Gregory. Nitin, who graduated from IIM-Calcutta, is currently pursuing a finance role with an automotive major. He has a deep interest in Macroeconomics and pens a blog at Gregonomics.

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