The Debt Mountain and Other Chinese Ghost Stories

Not quite an insurmountable mountain. Photo by SeongJoonCho/Bloomberg via Getty Images.

China has dominated headlines this month, from bouncy markets and hijinks with circuit breakers to the return of yuan devaluation worries. All are riffs on one overarching fear: that China's oft-predicted "hard landing" is happening now. After five years of waiting. Yet Godot hasn't arrived, and he doesn't seem likely to. China's growth is slowing, yes, but not dramatically, and the latest GDP figures beat expectations. But fear didn't fade. Instead, it morphed to another old worry: a foreboding "debt mountain" that threatens to bury China. We don't think this iteration of hard-landing fears is any more valid than its predecessors. Resurgent fears may weigh on investor sentiment in the short term, but China still shouldn't derail the global economy or bull market.

First, the GDP numbers: China grew 6.8% y/y in Q4 and 6.9% y/y in 2015-in line with the government's target of "about 7%" for the year. Yet headlines found reasons to mope, bemoaning the slowest growth in a generation^[i] and questioning the data's accuracy. ^[ii] While we, too, are skeptical, we hold that standard to all data, China or no-no one gauge or provider is perfectly accurate. More importantly, nothing in recent Chinese data suggest anything out of the ordinary: Growth is still slowing modestly as the government shifts the economy's focus from heavy industry to services and consumption. December industrial production slowed a bit from November, from 6.2% y/y to 5.9% y/y,^[iii] as did fixed asset investment, which eased to 10.0% YTD December 2015 vs. 15.7% over the same period in December 2014.^[iv] However, retail sales rose 11.1% y/y in December 2015, a tad slower than November's 11.2% y/y, but still darned fast on an absolute basis.^[v] And, for the first time, services comprise more than half of the economy, up from 48.1% to 50.5% in 2015. Manufacturing's share of GDP fell two percentage points to 40.5%. In short: The biggest chunk of China's economy is growing the fastest. Plus, despite all the fretting about slower growth, China still adds significantly to the global economy. Per Bloomberg, China's $10 trillion economy-more than two Japans-grew by about $645 billion in 2015, essentially adding another Sweden or nearly three Greeces^[vi] to the global economy.

However, a concern from several years ago-Chinese debt levels-has returned. Pundits claim China's debt is a ticking timebomb, citing a February 2015 report from McKinsey & Co., which pegged total debt (public plus private) at $28 trillion as of mid-2014-282% of then-GDP. Pundits argue China is digging itself into a deep hole by racking up debt to prop up growth, and getting ever-less bang for each borrowed buck. And according to some, this debt allegedly poses a big threat and drives "wasteful growth" that could produce a financial shock-and send the economy reeling-if not addressed.

Yet reality is far more tame. For one, that $28 trillion includes bank debt-an odd addition. Banking is built on debt: borrowing short term and lending long. However, this debt is depositors' and investors' assets, and given the nature of banking as a business, it makes sense to remove it from the analysis, a common analytical practice. The McKinsey study does as well, but the media didn't highlight that figure. Which is no surprise-it's not only a lower number, it also isn't hugely out of whack by global standards. Excluding bank debt, China's debt-to-GDP ratio falls from 282% to 217%.^[vii] That's lower than developed stalwarts like Japan, the UK and the US-and lower than other developing economies like Hungary and Malaysia.

China's opaqueness also makes it difficult to know the actual total amount of debt-it could very well be higher or lower than the McKinsey figure. The most recent official numbers show local government debt at 33% of GDP and central government debt at 23%-though this is from June 2013. While local government debt has risen and grabs headlines, this issue is well-known and has been for years-it isn't sneaking up on anyone. And despite officials' tough talk to rein in local government debt-including imposing spending caps-they also have quietly offered their support. Last April, the PBOC allowed banks to swap local government bonds for medium-term loans-similar to ECB's long-term refinancing operations (LTRO) program-probably getting some of the iffier loans off the books. The central government has also permitted local governments to raise money through government-sponsored banks, despite a previous policy designed to curb the practice.

As for corporate debt, though some sectors (i.e., commodity- and heavy industry-related) feel the pinch more than others, more companies are growing overall, so servicing their debt isn't an issue-and there hasn't been a rash of defaults in corporate bond markets. There have been occasional private and public bond defaults, but none brought the widely feared "Lehman moment." Also, after the initial defaults faded from headlines, the government quietly stepped in to either orchestrate last-minute funding or make bondholders whole. Though a setback in China's long-term progress in market-based reforms, it's also an unsurprising, business-as-usual move-the Communist Party values maintaining social stability over all else. Some also talk about consumers getting too levered up, and that's why retail sales and household spending are so strong. Yet this ignores rapid wage growth, a result of China's big urbanization push. If folks make more money, they can spend more money, too-spending isn't artificially higher because consumers have been borrowing to buy stuff.

Since Chinese "hard landing" fears arose in 2011, specific worries have cycled in and out. Local government debt going bad? Also 2011. There was also the real estate bubble of 2012^[viii] and manufacturing slowdown fears in 2013. We could go on. What headlines are bemoaning now isn't much different from what they bemoaned years ago. Yet since this global expansion began in 2009, has China crashed and taken the world down with it? Not that we're aware of. So when we see the return of "China debt fears," we fail to see what's different this time-especially when the actual data are about a year old, and there aren't any other new revelations. We believe better-than-appreciated drivers will overcome the current patch of dour sentiment as folks realize that a slower-growing China is not the same as a hard landing-and this disconnect from reality, as hard as it is to recognize during volatile times, is bullish.