The Unsustainable Foundation of China’s Deleveraging

After years of trying, in recent months Beijing has finally made headway dealing with one of the most intractable problems facing the economy: reining in the rapid accumulation of corporate debt. Not only has the pace of the country’s debt build-up slowed significantly, but according to JP Morgan estimates, in the second quarter of this year the size of China’s outstanding stock of debt stopped increasing relative to the size of the economy, an important sign that the pace of debt accumulation has slowed to a sustainable level.

Beijing’s greatest success, however, is that it has managed to bring debt under control while maintaining robust economic growth. Deleveraging was widely expected to be a fairly painful process, resulting in an economic slowdown, and yet the Chinese economy is the most buoyant it’s been for years. However, the current success might be short-lived. Beijing’s deleveraging is being underwritten by government borrowing and inflation, two conditions that it may not be able to sustain for much longer.

DEFICIT SPENDING

Firstly, Beijing has helped support growth by massively ramping up fiscal spending. In 2016, Beijing set the cap on the fiscal deficit for the year—that is, the amount of money that central and local governments could borrow to fund the budget—at 3% of GDP, up from 2.3% in 2015, an increase of about 500 billion yuan. But the increased deficit only tells part of the story. For the last two years, the government has been able to spend far more than taxes and borrowings would allow by running down fiscal savings.

The government generates fiscal savings when it borrows money and then doesn’t spend it. It can then use those savings to top up spending at a later date. In 2015, the government spent 700 billion worth of fiscal savings, and another 700 billion yuan’s worth in 2016—more than it raised by expanding the budget deficit. In effect, fiscal savings have allowed Beijing to stimulate the economy while keeping the budget deficit low. However, its ability to do so has likely run its course.

Government departments are allowed to hang on to their fiscal savings for only two years, after which they must return them to the higher authorities, which then redistributes them as part of the following year’s budget. Given that the government has been spending savings—rather than accumulating them—for the last two years, that would suggest that there is nothing left, or at least that what was left has already been handed back and redistributed. Data on the current year’s spending of fiscal savings won’t be published until next year. However, it seems unlikely that they’ve contributed significantly—if at all—to government spending in 2017.

That could explain why Beijing has front-loaded spending this year. At the end of August, the government’s budget deficit had already reached more than 1 trillion yuan, 400 billion yuan more than at the same point during 2016. From 2014 to 2015, the government’s budget was still in surplus at the end of the August (see Figure 1).

More Debt, Far Earlier

Figure 1. Level of Fiscal Surplus/Deficit Throughout the Year (100 million yuan)
Source: Ministry of Finance.

Consequently, if Beijing wishes to maintain spending at a comparable level to last year—and, by extension, to support economic growth—it appears likely that it will need to raise the budget deficit. At face value, that shouldn’t be a problem. By international standards, a budget deficit of only 3% is fairly low. However, China’s official deficit figure doesn’t capture the off-balance sheet borrowing done by local governments. According to the International Monetary Fund (IMF), once off-balance sheet government borrowing is included, China’s budget deficit at the end of 2016 was equivalent to 10% of GDP, up from 8% a year earlier.

There’s no way of knowing exactly how much additional GDP that borrowing generated, but according to a 2014 study by the IMF, one additional percentage point of fiscal spending relative to GDP typically generates at least 0.7 percentage points of economic growth. China’s experience wasn’t studied by the survey. Still, without the increase in deficit spending it is fair to assume that China’s economy would have grown well below the official level of 6.9%.

However, a budget deficit of 10% of GDP puts China’s government deficit at a level higher than India and Brazil, both of which have traditionally had a reputation for high levels of government spending (see Figure 2). If Beijing continues to use government spending to compensate for slower credit growth, then government debt will soon reach unmanageable levels. Already, warning lights are flashing, with Moody’s downgrading China’s sovereign rating in May on the back of concerns about government borrowing. But without such borrowing, China may have to become accustomed to significantly slower growth—and a far more painful deleveraging process.

As Bad as its Peers

Figure 2. China’s Annual Fiscal Deficit Compared with BRICs (% of GDP)
Note: For China’s fiscal deficit, we used the augmented net borrowing figure from the IMF’s 2017 Article IV report on China.
Source: IMF.

INFLATION

Prior to Beijing tightening credit at the beginning of this year, inflation was already surging, the result of ramped up government spending and relatively loose monetary policy in 2016. That increase in prices has had the welcome side-effect of helping to erode the debt burden of Chinese companies. In late 2016 and early 2017, the producer price index (PPI)—the measure of changes in prices paid for inputs by industrial and manufacturing companies—was rising by about 1% each month, equivalent to an annualized pace of about 12% (see Figure 3). The central government’s efforts to tighten the supply of credit helped rein that in, such that PPI is currently rising at an annual rate of about 6%.

Inflation is Back—For Producers

Figure 3. Recent Pick-up in Producer Price Index
Source: National Bureau of Statistics.

Note: Both charts show the change in PPI compared with the previous period, as represented by 100. For example, a reading of 100 means that PPI was unchanged from the previous period; a reading of 101 implies that PPI was 1 percentage point higher than in the previous period.

Previously, PPI had been falling for at least two years, the result of deflation that had exacerbated corporate China’s debt problems. Falling prices squeeze profits, giving companies fewer resources with which to repay loans, and forcing them to borrow more just to stay afloat. Resurgent inflation is now having the opposite effect, much to the benefit of China’s single most indebted group of firms—state-owned enterprises (SOEs).

Inflation has massively reduced the real cost of debt. Major state firms currently pay about 5% in interest on their borrowings, comfortably below the pace of PPI, making it far easier to service their debts. Consequently, SOE profits have risen by more than 20% in the past 12 months. More robust earnings mean firms have less need to borrow. Hence, the pace of debt accumulation at state firms has slowed from an annual pace of 18% in mid-2016, to around 9% this year. With state firms accounting for more than 40% of China’s total debt, the slowdown of SOE debt growth has been a major factor behind China’s nascent deleveraging.

State firms have been the big winners from PPI inflation for reasons other than just the extent of their indebtedness. Inflation has in part been driven by rising global commodity prices, which have a direct impact on the upstream industries that China’s state firms tend to dominate. Moreover, state firms have likely benefitted disproportionately from increased government spending, and also from the environmental crackdown that has seen small, private polluting factories across the country closed, which has reduced competition and driven prices up.

However, relying on inflation to resolve problems elsewhere in the economy carries certain risks. Even though the consumer price index has remained at very low levels for years, people in China’s major cities complain about the high—and rising—cost of living. If rising producer prices spill over into consumer prices, then the present course of controlling debt with inflation will cease to be sustainable.

Still, it’s encouraging that Beijing is making headway toward bringing debt under control. However, neither higher budget deficits or the tolerance of more aggressive inflation that have made it possible are sustainable in the long term—and may not be sustainable in the short-term either.