Most investors view the debt problem in China as a given. Yet, China’s debts are in line with debts in other EM countries given funding sources. China is a high saving/high investment/high growth economy and should have more credit outstanding, given its large domestic savings rate. The far bigger worry is that developed economies have considerably more debt with much lower savings rates.
Market participants are fond of expressing concern, even outrage at China’s alleged large stock of debt. How dare an Emerging Markets (EM) economy borrow nearly as much as the average developed market economy? Surely, China’s high debt stock must be unsustainable, evidence of gross misallocation of capital and hence a sure sign that the country is about to collapse with a hard landing.
The curious thing, however, is that analysts have been calling for such a hard landing in China every single year for the past decade and, yet, it has still not happened. It is time for investors to take the doomsday merchants to task: why are their dire predictions failing over and over again?
There are two principal reasons why so many analysts get China wrong. One reason is that they do not give adequate credit to the quality of Chinese investment. China has invested hugely in infrastructure, which, as in any other country would be regarded as beneficial, especially over the long term. The other reason is that investors do not pay enough attention to how China’s debt is funded. China has a relatively large stock of debt, because the domestic savings rate is so high. In fact, China has the world’s highest rate of savings at 48% of GDP. In practice, this means that the average Chinese worker stick roughly half of his or her pay check into a bank account every month. Over time, this has pushed the stock of deposits in the Chinese banking system to a whopping 177% of GDP (as at the end of 2015). Banks have no choice but to lend out this money, so it is the high level of deposits that constitutes the main reason why Chinese banks issue a lot of credit. The high level of credit in turn pushes up the country’s rate of investment, which in turn results in higher growth rates than in other countries.
It is absolutely essential, therefore, to recognize that China is a high-saving/high investment/high growth economy. In the context of the huge rate of savings, China’s credit numbers are far from outrageous. As at the end of 2015, China’s total domestic credit stood at 249% of GDP. This actually compares favorably to the 289% of GDP average level of credit in developed economies. Notice also that the Chinese banking system is not particularly leveraged (249%/177%), especially compared to Western banking systems that take in far fewer deposits, but lend out more than China.
Another way to illustrate the rather unremarkable nature of China’s debt stock is to compare it with other countries. To this end, we collected domestic credit and net savings data (both expressed as a percentage of GDP) for 42 EM and developed economies.2 The two charts below show the relationship between credit (as a % of GDP on the vertical axis) and net savings (as a % of GDP on the horizontal axis) for EM and developed economies, respectively. Each dot represents a country, the line through the dots is a simple regression line and the enlarged dots refer to China and the US in the two charts, respectively.
The following observations are important:
- China’s debt stock is normal, given funding: China sits very close to the regression line in figure 1. This indicates that China’s stock of domestic credit is entirely normal once account is taken of the country’s unusually high net savings rate. Hence, focussing solely on liability side of the balance sheet is wrong.
- China and other EM countries are generally far less indebted than developed economies: China’s outstanding debt is about the same as that of the US and below the average for developed economies, but given China’s much greater abundance of savings it is far less vulnerable to shocks. On average EM countries have 153% of GDP of domestic credit compared to 289% of GDP in developed economies.
- China and EM countries save far more than developed economies and tend to be self-funding: China saves more than 10 times as much as the US (49% of GDP versus 3% of GDP, respectively). China saves about eight times more than the average developed economy. Across EM countries, the average savings rate is more than twice as high as that of developed economies (13% of GDP compared to just 6% in the average developed economy). In fact, EM countries tend to issue more credit only if they are saving more, which suggests that they are capital constrained – i.e. they don’t have access to unlimited funding.
- By contrast, developed economies tend to save far less and rely on foreign savings: The relationship between domestic savings and lending for rich countries is flat to downwards sloping (fig 2). This means that the more indebted are not constrained by domestic savings and that, at the margin, they rely on foreign (EM) savings.
These simple relationships have important investment implications. The poor current policy mix in developed economies poses a potentially very serious risk to their financial stability. Quantitative easing, neglect of reforms, exorbitant debt levels and populism increase the risk that developed economies will not be able to repay their obligations the conventional way. Unless the situation gets better, it is only a question of time before EM central banks liquidate their investments in developed economies. This would not only create major currency realignments, but would also trigger significant retrenchment of consumption and therefore growth in developed economies
Jan Dehn is the head of research at Ashmore Group Plc, a specialist emerging markets asset manager with over US$ 50 billion under management.