For the past year, concern about the intensifying trade war between China and the United States has gone hand-in-hand with concern about the health of the Chinese economy. China’s dramatic rise as an economic power over the past two decades, and the deep interdependence of the global economy, means that Chinese economic performance has global ramifications for investors. That in turn means that the health of the Chinese financial system is also a paramount concern. We’ve written about this subject many times over the past few years. Particularly since the 2008–2009 financial crisis, China’s economic progress — like that of many economies — has come at the price of a build-up of financial leverage. As it grows, such leverage eventually creates risks of instability, so we monitor it — trying to see the areas where excesses may result in another crisis.
One of the trouble spots in China’s financial system remains the country’s highly indebted local governments. This hidden leverage recently came to investors’ attention again after an S&P Global analysis suggested that these hidden, off-balance-sheet debts may total as much as $6 trillion. We have been monitoring this area for several years. We brought it to your attention in 2017 with the following background piece explaining where, how, and why this indebtedness has occurred. Given all the stresses and rhetoric of the current trade conflict, we are sharing it again, and updating the current picture.
China’s Debt Binge: What It Is, Where It Came From, and Why
Sometimes China has been a geopolitical boogeyman, with journalists fretting about China’s rise on the world stage and its potential to surpass the U.S. in military or economic power. We have thought those fears to be baseless and have said so for years. China has a long, long way to go before it will be able to challenge the hegemony of the U.S. either militarily or economically, even in its own back yard.
Conversely, it has sometimes been China’s weakness rather than its potential strength that has spooked western observers. The fear here is that China’s decades-long boom has been a powerful stimulus to the global economy, and if that boom falters, it would drag the global economy into recession. A related fear is that China’s boom has been built on unsustainable financial leverage — on a domestic debt bubble that will result in a severe financial crisis.
The Root of China’s Problems
Excessive leverage in the Chinese financial system is a problem, and the authorities know it. This is why they have been working to reduce it for years, though without much success. The Chinese economy has faded and revved again each time the authorities have clamped down, and then loosened up as they couldn’t face the political costs of really reining in the dangers.
China’s rulers have two basic problems. One of them is of recent vintage — it has come about as a result of the country’s phenomenal success in creating growth and alleviating poverty. The other problem is not just old, but ancient — it has been one of the key recurring themes that has shaped China’s history for thousands of years.
Problem number one: growth must be maintained at all costs, or those who have been left behind — the hundreds of millions who are still poor and have not been lifted into China’s middle class — could revolt and overthrow the current rulers. Maintaining growth is a matter of existential survival for the Communist Party. This is why they blink every time financial restraints threaten to slow economic growth too dramatically… and they end up putting the pedal to the metal once again, even as the eventual crash becomes more likely and more severe.
Problem number two: there is a basic conflict between the center and the periphery. A famous 14th century Chinese historical novel, the Romance of the Three Kingdoms, opens with the words, “The empire, long divided, must unite; long united, must divide. Thus it has ever been.”
Here’s how this ancient Chinese problem is currently manifesting. The roots of China’s financial instability lie in a struggle between the central government, which has most of the revenues, and local governments, which bear most of the burdens of social spending. Those local governments were also responsible for most of the funding of China’s post-recession stimulus package. This impossible calculus meant that they had to find money somewhere. They found it by creating opaque “local government financing vehicles” (LGFVs) whose structures and risks were unclear, but which offered attractive yields and a tacit guarantee that the central government would bail out investors. Local governments were not permitted to float enough legitimate, above-board bonds to meet their financing needs. Also, if they were transparent about their financial state, no one would want the bonds.
So local authorities have created much of the problematic leverage in China’s financial system — not just because they’re in an impossible fiscal situation, of course, but because opaque financing affords all the participants lots of opportunities for corruption.
Current Developments: Where Do We Stand?
The pressures which have led to the current worrisome levels of local debt are still at work. S&P Global’s analysis, which concluded that hidden, off-balance-sheet local government debt likely totals $4.5 to $6 trillion, shows that LGFV growth is decelerating in response to the government’s deleveraging efforts, but is still significantly larger than formal local bond issuance.
China is still between a rock and hard place, and with the trade-war related slowdown, the hard place has gotten harder. In the past, some hidden local debt was allowed to be converted into bonds; economic pressure makes that less likely now. Such a move would increase China’s formal, visible debt burden and further shake global confidence about China’s financial stability. That would work against the Chinese government’s big geopolitical ambitions. China will want to counter the trade war slowdown with stimulus… but with local leverage already so high, it will be hard to turn those taps on without raising the risks of a crisis.
As we noted in 2017, the government does not have an “exit plan” for the local leverage bubble, except to grow out of it, gradually allow debt to be restructured into formal local government bonds, gradually allow some LGFV failures to chasten the public’s expectations, and gradually guide the economy into greater reliance on the consumer sector rather than heavy fixed-asset infrastructure investment. Engineering this “soft landing” remains challenging and uncertain.
China may have a long-term view and long-term geopolitical objectives that sometimes make U.S. politics seem short-sighted. But we should not underestimate the near-term pressures China is facing. The long term will not arrive for the Chinese Communist Party if severe financial and economic disruptions lead to political instability. It’s for this reason that we continue to believe that the Chinese are highly incentivized to reach a deal with the United States. When that deal comes, and how much pain they are capable of enduring in the meantime, we do not know.
Investment implications: Hidden local-government debt remains a big problem for China and poses significant risks of eventual financial instability. The central government has no quick and clear path to deleveraging that debt and reducing the risk, but is relying on a gradual deleveraging path supported by economic growth and a gradual shift to a more mature, consumer-driven economy. That need for continued growth means that China is highly incentivized to make a deal that begins to resolve the trade war. On the other side of the table, we believe the U.S. administration is also highly incentivized to make a deal ahead of the 2020 presidential election, in spite of its long-held concern about Chinese misbehaviors. In an atmosphere of mounting pessimism about global trade and economic growth, we believe it is important not to lose sight of these major incentives to resolve the conflict. A partial but significant resolution would likely have a galvanizing effect on global markets.
