China is groaning under the weight of its debt burden – but still shuns reform

China’s debt level has increased dramatically since the financial crisis in 2008/2009 and is now one of the highest worldwide. The inflated housing market, the shadow banking sector which has seen strong growth and numerous state-owned “zombie” companies present considerable risks and render the country vulnerable. Beijing is sustaining a vicious circle of efficiency loss, slowdown in growth and ever-increasing debt. There is a growing risk that these imbalances will culminate in a crisis at some point. However, due to the central government’s immense financial power, a systemic financial crisis should be preventable. Continued low economic growth, on the other hand, seems unavoidable.

The International Monetary Fund (IMF) and the Bank for International Settlements (BIS) are above all concerned about the strong momentum behind debt accumulation in China. They draw alarming parallels between its development and that of other countries which have recently experienced a financial crisis, such as Spain and Thailand. Although the situation in China is only comparable to developments in other countries to a certain extent because of the close ties between the private and public sectors, this does not mean that the risk is less substantial. Many government-owned businesses are “kept alive” by Beijing despite considerable inefficiency and overcapacity. Major state-owned banks grant them new loans in order to service the old ones. Alternative financing happens in parallel via the barely-regulated, strongly-growing shadow banking sector and is far riskier and more prone to default than conventional bank loans. Lastly, China’s real estate market is its Achilles’ heel: it has been considered inflated for a long time, but a correction would hit large sections of the economy.

In the light of this difficult situation, concerns that the country will eventually head for a crisis are certainly justified. A sharp correction in the real estate market or an economic slump could bring about a dangerous wave of loan defaults, which is why Beijing has been bracing itself vehemently against any such development. However, this has always led to even higher debt levels. Radical reforms are long overdue. Chinese leaders are well aware of this, but shy away from the growth disruption they would inevitably cause and the threat of a loss of control, only approaching the reform process with extreme reluctance.

On the other hand, Beijing probably does not have to worry about the debt spiral triggering a systemic financial crisis. The financial power of the central government is immense; thanks to the population’s highly liquid savings, its financial margins are all but limitless. It would have sufficient capacity to adequately capitalise the major banks, which are already state-owned, in order to survive a wave of loan defaults. However, the economic burden of this would be substantial and felt all over the world. Moreover, they would far exceed the extent of the growth losses, which would engender a rigorous reform process. Whatever happens, we must expect a significantly lower level of growth in China for the long term. Besides, we cannot be confident that the available data actually shows the full extent of China’s debt or whether the situation may in fact be far more serious.

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