Ever since the sovereign debt crisis in Europe and the pending one in the United States, investors and financial pundits have been wondering whether the next big shoe to drop was in China. After all, it’s the world’s second largest economy after the U.S., and its government spends like a drunken sailor.
While the chances of a full blow China debt crisis are low, the risk is real, warns Barclays Capital in a 31 page report released Monday.
China is a closed system. The debt remains in the hands of the public. Foreign entities pose no real threat to it,unlike in other countries where foreign investors could sell out of debt or short it, causing large spikes in yields and making interest payments less affordable. Think Greece and Spain for example. China is at no one’s mercy, except its own.
The real result of China’s overspend is a Japanification of its economy in the long-run. For the country itself, it might not be such a terrible thing. Japan is modern. It is home to some of the biggest brands in the world. Society is stable and middle class. China is not yet any of those things. And while comparing China to Japan is like comparing Brazilian soccer players to Argentinians, the debt of the Chinese government and its state-owned banks is growing and that points to a slowdown in the China growth story.
That slow down is not five years away. It is now. One of the reasons why China is not going to grow double digits is because Beijing knows it has to cool it on its fixed asset investment plans, many of which have been wasteful.
The good news is that most of that investment has not been wasteful. And so it would appear, by Barclays’ own analysis from their staff in Hong Kong, that stagnation is more likely the outcome than a European style debt crunch in a worst case scenario.
There are several factors supporting the case for a low probability of fiscal stress in China, Barclays Capital analysts led by Yiping Huang wrote in the report.
Neither Broke, Nor Breaking
Despite its high level of total government liabilities $23-46 trillion yuan – the government’s balance sheet remains healthy. China’s debt-to-GDP ratio is around 65 percent compared to over 100 percent for the U.S. and more than 200 percent for Japan, including all public debt and contingent liabilities.
The latest available Ministry of Finance data showed that in 2009, assets of state-owned enterprises (SOEs) totaled $53.3 trillion, of which $27.9 trillion belonged to the central government and $25.5 trillion belonged to local governments. In other words, right now, the central government’s assets are still sufficient to cover its liabilities.
Second, the Chinese government remains in a strong fiscal position, owing to rapid revenue growth from taxes and fees and Beijing’s prudent fiscal management. Fiscal revenue rose 25 percent to a record $10.4 trillion in 2011. The total budget deficit was just 1.1 percent of GDP, even after a 21 percent yearl increase in expenditures to $10.9 trillion, Barclays reported. Even including contingent liabilities, total public debt remains manageable. Using different assumptions of the country’s pension fund gap, the ratio of China’s national debt to its GDP ranges from 62 percent to a high 97 percent.
Lastly, China has several options available to finance its rising liabilities. Barclays sees the pension fund problem being the biggest long term drain on government resources. The one-child policy has led to less workers supporting more retirees.
Drawing from international experience, the World Bank suggested that China could raise contribution rates, or use general revenues or dedicated social security taxes to cover contingent liabilities, in addition to direct transfers of state-owned assets. Beijing could issue more debt, and local governments could gradually be allowed to tap the capital markets for more debt financing instead of relying on the center.
What does this mean for the Chinese economy?
As the government spends more to finance its contingent liabilities, the cost of capital in China should rise, Huang writes.
“This is in line with what we would expect following financial liberalization,” Huang says in the report. “Higher costs of capital may further squeeze corporate profits, increase financial market volatility and result in the consolidation of some heavy and highly leveraged industries.”