The growth rate of China's gross domestic product (GDP) in 2018 was 6.6%, the lowest since 1990 when the Chinese economy was negatively affected by the Tiananmen Incident. As the U.S. economy may slow down further, there is growing uncertainty over the prospects of the world's two largest economies, which together account for 40% of global GDP.
While the credibility of Chinese statistics is not very high, there are many unclear points regarding the situation of the Chinese market and the Chinse government's response. The lack of transparency is fueling a concern that the current state of the economy could be worse than is indicated by the data announced by the Chinese government. Financial markets around the world are expected to continue to be sensitive to the impact of the U.S.-China trade war on the Chinese economy and developments in the Chinese financial markets.
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In addition to the U.S.-China trade war, the massive debt China owes is a problem for the Chinese economy. According to Bloomberg, as of 2017, the total amount of debt in the entire Chinese economy is 32.5 trillion dollars (266% as a proportion of GDP), representing a 4.4-fold expansion (1.6-fold increase as a proportion of GDP) over a 10-year period. Of the total amount of Chinese debt, 60% is made up of corporate-sector debt, which also increased more than four-fold. Recently, as the economy has slowed down, the number of bankruptcies has risen to a record high.
The total amount of Chinese debt has expanded rapidly since 2009, the year after the collapse of Lehman Brothers that triggered the global financial crisis. That was mainly because corporate-sector debt grew rapidly following fiscal stimulus and active investments in the construction, real estate, and infrastructure-related industries. The massive fiscal stimulus was implemented to counteract a steep decline in exports.
In response to the stimulus measures, the Chinese stock and housing markets both performed strongly. Usually, at the time of market overheating, China's monetary authorities try to stabilize the markets by conducting market interventions—such as requiring banks to adopt stricter lending standards and strengthening the regulations on shadow banking activities (i.e., financial activities that provide finances while bypassing banks as intermediaries). When the markets weaken, the authorities would do the opposite, i.e., weaken market interventions.
In fact, around 2017, amid concerns over the rising corporate debt, the Chinese government implemented policy measures to curb credit provision to companies and cut back on the debt overhang. By mid-2018, the effects of those measures became evident. In essence, the government's active efforts to curb credit expansion had already weakened the economy by 2018, and the U.S.-China trade war aggravated the economic situation, hitting the manufacturing industry hard.
Within the corporate-sector debt, dollar-denominated debt in particular has rapidly increased since around 2011, growing to about 45 billion dollars as of the fourth quarter of 2017 (see the figure below). Although the share of dollar-denominated debt out of total corporate-sector debt is not high, it can have a significant impact on corporate finance since it links domestic finance in China with international finance.
Not only in China but also in other emerging markets, has the amount of dollar-denominated debt has increased rapidly since the beginning of the 2010s. As developed countries actively implemented monetary easing after the outbreak of the global financial crisis in 2008, the vast amount of funds that had flown into the United States and Europe started flowing to emerging markets in pursuit of higher yields. Taking advantage of the low interest rates in the U.S. and the strength of their domestic currencies, companies from emerging markets raised funds in the dollar and actively made investments. This also applies to China; following the yuan's appreciation, Chinese firms issued a large amount of dollar-denominated debt.
However, after the U.S. Federal Reserve Board (FRB) ended the zero-interest-rate policy and started monetary tightening at the end of 2015, funds started to flow from emerging markets back to the United States. After the pace of tightening picked up in 2016 and 2017, the trend of funds flowing back to the U.S. strengthened further. Emerging market currencies depreciated as the U.S. interest rates rose and the Trump administration implemented fiscal expansion, including a large-scale tax cuts, all of which further contributed to the dollar appreciation.
As a result, the burden of repaying dollar-denominated debt grew (in terms of domestic currency), stressing the balance sheets among firms in the emerging markets. That led investors to withdraw funds from emerging markets, exacerbating financial market declines.
In a similar fashion, the Chinese yuan depreciated, which caused the current vicious cycle. The yuan depreciation increased the burden of repaying debt among firms that had actively issued dollar denominated debt, further increasing downward pressure on stock prices and the yuan. As of now, the yuan's value relative to the dollar is down around 6% compared with January 2018, while the Shanghai Composite stock price index is down more than 20%. This vicious cycle surely affects the real economy and will continue to be a headache for China as long as the dollar remains strong.
Following the current economic slowdown, the Chinese authorities are expected to implement fiscal stimulus, relax lending standards again, and provide subsidies to distressed companies and industries. Given that the size of national debt is relatively small (compared to its economic size), the Chinese government has sufficient room to actively implement macroeconomic stimulus measures and bail out financial institutions even if corporate and bank failures increase.
China holds foreign exchange reserves totaling around 3 trillion dollars, but now that China's external debt has expanded to 1.9 trillion dollars, the country does not necessarily feel at ease as it used to. Even so, the Chinese authorities should be able to implement all necessary measures to prevent financial instability. Hence, the risk of China experiencing a financial crisis should be low.
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However, China's macroeconomic measures are not free of risks.
First, stabilization measures could allow so-called "zombie companies," or companies that should have been ousted from the market, to stay afloat, which would result in an inefficient allocation of resources and could inhibit structural changes and long-term growth of the Chinese economy.
In 2017, China's GDP share of the tertiary industry (mainly composed of service industry) increased to 51.6%, surpassing for the first time the share of the secondary industry, mainly composed of manufacturing and construction (40.5%). Hence, China should implement stimulus measures in a way that would promote a structural reform of the economy, from a manufacturing-oriented one to a service industry-oriented one. However, politics can be an obstacle. That is, China is highly likely to allocate resources via state-owned enterprises and banks to industries with a relatively low level of productivity, such as construction and related industries, heavy industries, and the manufacturing industry, the latter of which now has stopped adding high value to the economy and has lost significant international price competitiveness.
Even if the stimulus measures raises the production levels of protected industries, if the domestic consumption of the products from those industries remain weak, the resulting excess, low-priced goods would be exported to foreign markets, possibly escalating the trade tension with other countries, and the United States in particular. Relaxing lending standards for some particular industries as protective measures might only increase non-performing loans in the future as well. That would plant new seeds of financial instability.
Moreover, many Chinese companies may continue to pursue dollar-denominated funds to avoid domestic regulations. That would mean that through international finance, the Chinese economy would continue to be directly affected by economic and policy developments in the United States.
In this globalized world, many researchers argue that global trends in financial and asset markets are set by major countries, especially the United States. Therefore, other countries have no other choice than to follow the trends thus set. However, China is eager to keep its domestic economy stable and maintain its independence as an economic superpower instead of constantly being exposed to shocks from major countries, particularly from the U.S.
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In order for China to maintain economic independence, it is essential to internationalize the yuan. If the yuan circulates freely in the international markets and thus becomes more convenient to use, Chinese companies could raise yuan-denominated funds abroad. That will mitigate the risks related to the fact that the debt burden in China and the entire Chinese economy are always subject to the fluctuations of the dollar and other foreign currencies.
By definition, the yuan is an international currency since it became one of the composite currencies for the International Monetary Fund's Special Drawing Right (SDR) in 2016. However, in practice, it cannot yet be said that it has become one of the main international currencies. The use of the yuan is still limited in terms of international trade, cross-border financial transactions, and foreign exchange reserves held by central banks. As long as China continues to arbitrarily intervene in the financial markets via state-owned enterprises and banks, the yuan cannot gain the trust of investors or credibility as an international currency.
In the short term, the Chinese economic authorities have sufficient resources to contain recession or financial instability, so it is unlikely that China will become the source of a global recession or financial crisis. However, if China mishandles its financial and economic problems, stress could build up within its economy and financial system, increasing financial and economic vulnerabilities in the future. The success or failure of China's efforts to avoid such a situation will depend on whether political leaders implement policies based not on political calculations, but on a long-term vision of the Chinese economy.
* Translated by RIETI.
February 15, 2019 Nihon Keizai Shimbun
