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2017-09-14Macro `n Cheese

The Chinese wall of debt

Roger takes a look at whether China will ever exit the middle-income trap

There are a number of issues being discussed in financial markets that almost seem to have taken on a life of their own. At the very least, and from time to time, these issues have the ability to reanimate themselves; the Euro-crisis and Japan’s debt level are two examples. Another such subject that I thought I would touch upon here is the sustainability of the Chinese economy.

China, getting old before getting rich

To begin, let’s look at a few important fundamentals.

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Figure 1: Will China get old before getting rich?

As can be seen, population growth has been at a saddle point over the past few years, but is expected to decrease in the near future and to start to shrink outright no later than 2030. Simultaneously, the dependency ratio (young and elderly expressed in per cent of the economically active population) is increasing, partly due to low fertility but mainly due to an increasing number of elderly. The old age dependency ratio has risen rapidly over the past few years and is currently around 15%.

Undoubtedly, within arm’s length of the “Lewis turning point”1 (LTP), the Chinese leadership is trying to steer clear of the middle-income trap that has ensnared so many other would-be industrialized countries. Indeed, providing some comfort for policy makers since the turn of the millennium (and as can be seen in the graph above), real incomes have risen in excess of 10% per annum and wage levels are often cited as being well above those seen in other major developing markets2.

1 A much discussed IMF-study on China ( put the LTP between 2020 and 2025, while Cai et al ( point to China’s LTP being behind us

2 Confer and for a few recent examples

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Figure 2: Income discrepancies are widening and rural population share still very large

Did China just drive straight through the Lewis turning point?

However, this is mainly a manufacturing/services phenomenon, while agricultural and most other primary industries are lagging severely behind. This contradicts one of the basic tenets of LTP – that  labor markets should have become geographically integrated and wages depend on the marginal product of labor (i.e., moving towards the neo-classical model). Furthermore, and underlining any doubts, the urban population share is only around 55%, which is far below most developed countries, in which the urban population share is often around or above 80%. (There are also other anomalies, e.g., the declining labor share of GDP.)

These qualifications suggest that: (I) Either, structural impediments exist3 that need to be dealt with for China not getting stuck in the middle-income trap, or; (II) there is still considerable slack in labor resource utilization and the LTP still lies ahead.

From this perspective, the economy’s response to developments over the last few years has been less than comforting. As capital controls have been tentatively relaxed, and the Yuan was allowed to appreciate, GDP-growth stagnated. Admittedly, this is not, per se, incompatible with the stylized LTP-discussion above.

3 For an overview that seems recent and decent, see:

Or have they taken the debt high way?

However, and unfortunately, signs of inefficiencies in capital allocation have also ensued, raising some pertinent questions on the sustainability of China’s economic model. Could it be that China has borrowed, invested and grown, but without any notion of future utility from these investments?

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Figure 3: Credit is the defining trait of Chinese economic developments

According to BIS data, before the global financial crisis (GFC), China needed (on average) one unit of credit to create one unit of GDP. After the financial crisis, however, 2½ units of credit is required to create one unit of GDP. There also appears to be a worrying trend towards the ever higher credit content of GDP. In addition, changes in the flow of credit (also expressed in % of GDP), often called the “credit impulse”, seem to be leading both real and financial developments, such as house prices, for example. 

Under any circumstances, higher credit intensity during the years following GFC, implies that China has also posted a tremendous rise in indebtedness, which is clearly visible in the chart below. The rise in the debt ratio has not only been swifter than in Emerging Markets at large (including China) and faster than in almost any other country, but is now at levels comparable to many advanced economies.

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Figure 4: Higher GDP-growth, but even higher debt growth

Shouldn’t higher risks imply higher returns?

As with all debt build-ups there is of course another, more sanguine, story to be told. Perhaps China is simply building up its capital stock; capital which will produce strong growth for years to come and result in high productivity and incomes for business and households alike. After all, this is what traditional growth theory suggests; developing economies borrow4 and invest. In the same vein, lower investments and debt growth should be expected for advanced economies. There is no way to, ex ante, decide what is a correct interpretation of the above developments.

That said, including a few more graphs can hopefully cast some more light on the particular developments of China. The graph above shows that China’s and other EMEs’ debt ratio is rising rapidly (in China it is close to the debt ratio of Advanced Economies). Advanced Economies demonstrate a more moderate rise, which fits the stylized view of a developed economy.

4 Of course, China has been a capital exporter of some magnitude as demonstrated by its consistent and high current account surpluses.

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Figure 5: Corporate debt ratio and ROE

Note: The ROE:s are collected from an MSCI add-in database in Macrobond, which is only accessible at an extra cost. Note, also, that the debt ratio discussed here might have its flaws, since the denominator does not correspond to the non-financial corporate sector income, but should be regarded as a proxy.

To be clear, a higher corporate debt level is of course another possible explanation (e.g. via the composition of the business sector, such as a high share of heavy industry), but given that we tend to invest in emerging markets assuming a higher risk (i.e. accept higher volatility) we would expect the Chinese and Emerging Market corporate sector to have created larger buffers (i.e. demonstrate a lower debt ratio), no?

In China’s case, the non-financial corporate debt ratio is twice as high as in advanced economies, and EMEs as a group also post a higher debt ratio than advanced economies. With that kind of leverage and, by inference, capital you would be forgiven for expecting equally impressive return on equity (ROE). But this is, as can be seen, not the case. Instead, advanced economies have had a higher ROE than China and Emerging Markets ever since 2012.

Another tiger walking dead?

It is important to recognize that China might well be on the verge of a growth and welfare boom, which will catapult the economy way past the LTP and into the coveted Advanced Economy status, satisfying investors manifold in the process. But, there is also plenty of evidence to the contrary. In particular, signs of misallocation of resources are emerging, with the combination of a high and rising debt ratio and low ROE being one example (underlying depreciating pressures on the Yuan over the past few years, despite a continued strong current account balance, could be used as another). Or, to put it even more provocatively: The still rather low government debt ratio and impressive FX reserves will probably come in handy.

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We don’t usually have views and opinions about economic and financial states of affairs, (not ones that we express publicly as a company, anyway). We do believe, however, that people can and do appreciate a variety of perspectives. What you’ve just read is the perspective of our resident chief economist. While we think he’s very smart, Macrobond Financial does not expressly endorse the views he presents here. And, as the old adage goes, you shouldn’t believe everything you read (not without finding the data, performing a few analyses and presenting it in a nice chart). We want to make it clear that we are not offering this information as investment advice. That being said, if you have the application you can easily check everything that’s mentioned here, and decide for yourself. If you don’t have the application, now you have a great reason to get it.