Why China Won’t Suffer a “Debt Crisis”
By JOHN ROSS
Inaccurate articles sometimes appear in the Western media claiming China faces a “severe debt crisis.” Factually these are easily refuted. Changyong Rhee, the IMF’s Asia and Pacific Department director, recently pointed out that China’s national and local government debt is only 53 percent of GDP, while the U.S. government’s debt is roughly equivalent to GDP, and Japan’s government debt is 240 percent of GDP. Foreign debt is nine percent of China’s GDP – insignificant bearing in mind that it owns the world’s largest foreign exchange reserves.
Factually, it is therefore unsurprising that China’s predicted “Lehman” or “Minsky” moment, a financial collapse, invariably fails to occur. But there is another, even more fundamental, reason why China’s economy does not suffer severe financial crises of the type that struck the Western economies in 2008 or wracked the Eurozone. As this illustrates how China’s economic structure is superior to the West’s it is worth analyzing.
Starting with fundamentals, the way the argument is constructed wherein China faces a “serious debt crisis” violates the most elementary accounting rule – namely that of double entry book keeping, which was invented in Italy “merely” eight centuries ago! It denotes that for every debit entry there has to be a credit one, and vice versa. Discussion of only one side of a balance sheet without the other is financial nonsense. Claims, such as in the Financial Times, that the big story of 2014 is “the black cloud of debt hanging over China” are financially meaningless given they do not discuss assets as set against debt.
To illustrate this elementary accounting principle take a simple example. A company borrows US $100 million at 5 percent interest, uses it to build houses, and sells them at 15 percent profit. To declare “there is a crisis – the company has a US $100 million debt” is evidently nonsense. The company has debts of US $100 million but assets of US $115 million. It can repay US $105 million and make US $10 million profit – there is hence no “debt crisis” whatever. That its assets are greater than its debt illustrates why it is financially illiterate to discuss only debt without assets. A “balance sheet” is so called because it has two sides, not one.
Apply this to China and the West’s financial systems. Evidently no financial problem exists in either if a borrower makes a profit on a loan – they repay it. A problem only exists if the borrower does not make sufficient money to repay the debt.
If the borrower is a small or medium one, again there is no difference between Western and Chinese financial systems. In both cases the borrower partially or fully defaults and, if necessary, goes bankrupt.
Specific criticisms can be made, which this author would tend to agree with, that in the West’s system companies are sometimes too easily allowed to resort to bankruptcy to escape debts. China, meanwhile, has propped up some companies that would have been better allowed to go bankrupt. But these are details that do not affect the essence of the matter. China is now taking a more robust line in forcing into default small and medium borrowers that cannot repay loans. Shanghai Chaori Solar Energy Science and Technology recently defaulted without bailout.
But, by definition, individual bankruptcies of small and medium companies do not affect the financial system’s viability – they are a normal part of market functioning. The key difference between Chinese and Western financial systems comes from debts by large institutions – “system making” ones to use technical economic terms. Here Western and Chinese systems differ – and China’s is superior.
First take Western government debt. As Western governments ideologically oppose state investment, Western state borrowing is overwhelmingly used not to finance investment but consumption, via social security payments, unemployment pay and etc. For example, in the U.S. at the depth of the post 2008 Great Recession, annual government borrowing was 13.6 percent of GDP but state investment was only 4.5 percent – borrowing overwhelmingly financed consumption. As Western government debt primarily finances consumption it therefore creates no lasting asset. That is why in the West it is not wholly misleading to look at state borrowing purely from the debt point of view – even if it is wrong conceptually.
China’s is different. The bulk of borrowing, particularly by local governments, is for investment, primarily in infrastructure. Borrowing therefore creates lasting assets – roads, subways and housing. Assets in turn create revenue streams directly, indirectly, or both. Direct revenues are fares, rents, and tolls. Indirect revenues are generated because infrastructure investment promotes economic growth, yields taxes, and has well-known effects in raising land values – land sales being one of Chinese local governments’ biggest sources of income.
As China’s government debt is used for investment, not consumption, analysis that does not financially offset debt with assets created by them is not merely formally wrong but constitutes a serious actual mistake. Similarly, company borrowing is primarily used for investment, i.e. asset creation.
This leads to a final difference between China and the West. In both Western and Chinese financial systems, if the value of an asset created by borrowing equals at least the value of the debt, there is evidently no problem. The difference between the two comes with bad investments – where the value of the asset created does not equal the borrowing.
A major financial crisis occurs when there are large-scale bad investments by “system making” institutions, those that are “too big to fail.” This need not be a single bad investment but can be large numbers of small bad investments, as with the U.S. sub-prime mortgage crisis. In these cases, in both the West and China, only the state has the resources to solve the problem. But the way the state intervenes is entirely different in China and in the West.
