The rise of Chinese off-balance sheet debt
I am sometimes asked why I look at total outstanding credit to GDP as a measure for indebtedness in an economy, rather than government debt to GDP. The short answer is that we have learned from the Global Financial Crisis and the Eurozone debt crisis that what starts as private debt very quickly becomes government debt in a crisis.
The long answer can be seen in the case of China. We all know that the level of debt to GDP in China is very low when we consider only government debt. According to the Bank for International Settlement (BIS) it was 48.3% of GDP at the end of the third quarter 2018 (the latest official data available). In recent years, the Chinese government, together with the People’s Bank of China (PBOC), has put pressure on local governments and municipalities to keep debt under control and even reduce their debt load to deleverage the economy.
This pressure has been lifted somewhat in 2019, as I have explained in the China report released yesterday , in order to stop the current economic slowdown. Much of the heavy lifting seems to be done by “special purpose bonds”. These special purpose bonds are issued by municipalities and linked to specific projects. The structure is similar to revenue bonds issued by municipalities in the US: the coupon payments of the bonds as well as their capital is linked directly to the revenues of a specific project like a toll road, bridge etc. In theory, the default risk of these bonds is independent of the fiscal situation of the municipality and thus should not be part of the municipality’s balance sheet. This is correct from an accounting perspective and as long as these special purpose bonds are allowed to default if a project is unprofitable, there is no problem with these structures.
The problem arises if a country like China issues too many of these special purpose bonds linked to infrastructure projects that nobody needs and are uneconomical. In the case of a mass default of these special purpose bonds, local governments or the central government in Beijing may be forced to honour these special purpose bonds to avoid a nationwide credit crunch.
China certainly is the country with the best infrastructure in the world right now but the Chinese boom in infrastructure spending has led to some doubtful projects being financed. And now that the country’s economy is slowing down fast, more of these special purpose bonds are issued every month. This is done to finance additional infrastructure projects without increasing the government debt/GDP ratio – a development that could spook global financial markets. It is effectively a huge exercise in window-dressing.
According to Bloomberg, the country had $1.1tn of these special purpose bonds outstanding at the end of 2018. This is the equivalent of 8% of GDP. In 2019, the country plans to issue another $330bn in these special purpose bonds, or the equivalent of 2.5% of GDP. Taken together, Chinese government debt is likely closer to 60% of GDP than 50% and growing at 2.5% of GDP per year. And while these numbers are still quite low, the fast growth, together with the vast amount of other private debt, make them a challenge for the government and the PBOC in the transition of the economy during the next decade. It’s not a problem in 2019, but if this trend is not reined in at some point in the near future, it might become one further down the road.