Article
12 Apr 2021

China Economics: Rising Leverage and the Policy Dilemma

Global Insights
Contributor(s): Citi Global Insights
Drawing on China economist Li-Gang Liu’s analysis, we look at the challenges facing China’s policy-makers in balancing an exit from a supportive monetary policy with the need to avoid a surge in corporate defaults and risks to the financial system.

China’s overall debt to GDP ratio rose by 29ppt to 315% in 2020, led by increased borrowing by corporates and provincial governments. Elevated leverage ratios normally portend a tightening of monetary policy. Higher interest rates, though, could trigger distress for Chinese companies that are highly indebted. Drawing on China economist Li-Gang Liu’s analysis, we look at the challenges facing China’s policy-makers in balancing an exit from a supportive monetary policy with the need to avoid a surge in corporate defaults and risks to the financial system.

During 2020, debt levels for corporates in China went up by 10.4ppt to 162.3% of GDP, for households by 6.7ppt to 62.2%, and for provincial governments by 8.6ppt to 69.4%, though by only 3.5ppt to 20.6% for the central government (Figure 1). The overall debt to GDP ratio rose by 29.2ppt to 314.5%. Meanwhile, asset prices also rose at a fast clip. With the economic shock from the pandemic having receded in China, the expected response by the People’s Bank of China, the central bank, to rapidly rising leverage would be to tighten monetary conditions. However, any such policy re-setting will require caution and deftness given corporate vulnerability to higher interest rates.

Figure 1. China: Debt By Sectors

Source: CAAS, BIS, IMF, MoF, Citi Research

 

Monetary policy easing during the pandemic seems to have resulted in different responses by the private sector and state-owned enterprises (SOEs). Debt to assets rose by 0.8ppt for SOEs, but declined by 0.4ppt for private firms. The high corporate debt to GDP ratio of 162.4% in 2020, on the estimate of economist Li-Gang Liu, breaks down as 112% for SOEs and 50.3% for non-SOEs.

At the level of listed private companies, in a scenario analysis by Li-Gang Liu, a 1ppt rise in interest rates for the most leveraged firms would shrivel their profits by 30% (assuming their debt is mostly financed by banks). Unlisted small, medium and micro-level firms, which rely heavily on bank loans and shadow banking, also face significant challenges. Commercial banks were asked to lend to these firms with quotas during the pandemic, and their interest payments were either subsidized by fiscal authorities or set at below-market levels.

Pre-tax profit margins of private firms were higher than the weighted average lending rate in January–February (Figure 2). However, the size and private ownership of some of these firms may mean they pay much more than the weighted average lending rate. Funding costs could already be higher than their profit margins. Not only may borrowing come at a higher price this year, the availability of loans could diminish, partly owing to a sharp shrinkage by banks of off-balance-sheet activity. Against this background, the State Council is allowing smaller firms to continue to delay payment of both principal and interest until the end of 2021.

Figure 2. Corporate Lending Cost vs Profit Margin

Source: CEIC Data Company Limited, Citi Research

 

Rising leverage ratios would normally be expected to lead to the PBoC starting to exit its supportive monetary policy. However, aggressive policy tightening would raise the prospect of the most highly leveraged firms defaulting on their debts, with potential implications for the stability of the financial system. Thus, high leverage ratios might instead prove a persuasive argument for a relatively slow and extended PBoC policy exit.

For more information on this subject, please see China Economics: How Much Has China Levered Up Post the Pandemic?

Citi Global Insights (CGI) is Citi’s premier non-independent thought leadership curation. It is not investment research. The comments expressed herein are summaries and/or views on selected thematic content from a Citi Research report. For the full CGI disclosure, click here.

 

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