China’s Growing Debt Problem

by Rana Foroohar,

A new hurdle for the world’s second largest economy.

One of the most telling economic events since the financial crisis has gone almost entirely unnoticed. A few weeks ago, China had its first corporate-bond default. The company in question, a solar-energy-equipment firm called Shanghai Chaori, was small, private, highly leveraged and not very important. But the default speaks volumes about the state of the world’s second largest economy. China is in the middle of a debt crisis the likes of which we haven’t seen since the fall of Lehman Brothers. Chaori’s default was tiny by comparison. It couldn’t make a payment on a $163 million bond; Lehman owed $613 billion when it folded. But it’s the tip of an iceberg that is now nearly double the size of China’s GDP. By allowing Chaori to go bust, the Chinese signaled they’re no longer in denial about the problem.

That matters in a country in which statistics are precooked and every economic move, even the run-up in debt itself, is planned. Back in December 2008, I met in Beijing with Jiang Jianqing, the head of ICBC, China’s largest financial institution. He acknowledged that the massive government stimulus program that was put in place to cope with the global slowdown would result in a higher percentage of bad Chinese loans. After all, when Beijing says, “Lend,” state-owned banks ask, “How much?” even if borrowers aren’t creditworthy. China’s biggest banks wrote off more than twice the level of bad loans last year as they did in 2012.

That’s no surprise given the size of China’s debt bubble. Over a year ago, Ruchir Sharma, head of emerging markets for Morgan Stanley Investment Management, pointed out that China was pumping out credit faster than any other country. The problem: much of it went into dubious public-sector investment (unneeded rail lines and housing projects) rather than productive private enterprises. Five years ago it took just over a dollar of debt to create a dollar of economic growth in China. Today it takes four dollars of debt to create a dollar of growth. Those are crisis numbers by any standard.

A financial crisis in China isn’t the same as one in the U.S. For one, Chinese debt is almost completely Chinese-owned.

“It will be difficult for China to have a Lehman moment,” he says, “because China can always find a buyer of last resort somewhere in the state system.”

That sounds good, but it also means China can let its debt crisis fester. That will only make things worse in the long run, increasing moral hazard and slowing economic growth, which may be as low as 5% this year. (That’s down from double digits a few years back.) Worse, the government is already using those figures as a reason to backtrack on its recent promises to reform the economy. Beijing is now talking about more stimulus to keep the country’s growth rate up around the 7% it says is needed to keep unemployment from reaching dangerous levels. China’s leaders fear unemployed masses taking to the streets.

Trouble is, the argument that more debt is needed to keep unemployment down no longer holds water. As Sharma points out, every percentage point of GDP growth now creates around 1.7 million new jobs–up from 1.2 million a decade ago. Also, fewer young people are coming into the workforce as the population ages. That means even 5% growth would likely keep the Chinese economy stable. So why isn’t the country doing more to deflate its debt bubble and change its economic model? Because as in the U.S., the political and economic elite have little impetus to change a system that has made them fantastically wealthy.

Will China be a drag or a boon to the global economy? Perhaps more than at any other time since the country began its transition to capitalism some 30 years ago, the answer is as blurry as the air in Beijing.

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