China needs reform to tackle rising debt: S&P

S&P has told China that only decisive reform efforts will rescue the nation from its grave debt challenge.

S&P says China’s credit issue is a major global concern.

China’s ruling Communist Party is being reminded on the eve of its crucial 19th National Congress of the Communist Party of China, that only long-postponed, decisive reform efforts will rescue the country from its grave debt challenge.

Three weeks after cutting China’s sovereign credit rating for the first time in 18 years, Standard & Poor’s has published three separate reports on credit issues in the country — as if to underline the depth of research that went into that historic decision, and to urge the government to respond appropriately.

Before the global financial crisis a decade ago, S&P says, productivity and net exports provided meaningful support to investment-led growth. However, since then, “growth has been supported by sharply rising bank lending and debt creation”.

While the Chinese authorities acknowledge there is a problem here, there is no consensus around the solution. Beijing believes “Chinese characteristics” will allow for a smooth downward adjustment, says S&P, while others insist on a period of sharply lower credit growth, plus deleveraging and output growth.

The ratings agency says China’s credit issue is “possibly the most important question facing the global economy”.

The key difference between the two main points of view on the issue is no longer whether there is a credit gap, it says, but the speed of adjustment: “How much time do the Chinese authorities have to fix the problem?”

The “hard landing” camp, it says, believes “China has entered a danger zone where a domestic savers’ or interbank market creditors’ strike forces a sharp drop in credit and GDP growth to restore the economy to a more sustainable path”.

This camp says that authorities’ efforts to secure a smooth landing may be undone by Chinese savers and domestic creditors — “and once these events get started, they may be hard to stop.”

S&P outlines two possible triggers. A savers’ strike, breaking the link between robust wages growth driven by a tight labour market and the substantial deposit growth needed to fuel strong credit growth.

And an interbank creditors’ strike, disrupting a key funding channel for China’s “long tail” of smaller, weaker and less diversified banks that are net borrowers in that market, disrupting credit creation even if deposits kept growing.

In contrast, the case made by the authorities, as portrayed by S&P, is that the economy is largely self-funded, with China’s savings exceeding its investment, with wage and deposit growth strong, with powerful levers available including state bank lending to real estate and infrastructure, and with an impressive track record of macro-management.

The agency points out that “at an abstract level, each of these two views is logically consistent”. But one of them must be wrong.

Using a simulation model, it concludes that the two key variables — the size of the credit-to-GDP gap and the amount of time the authorities have left to close that gap — are contingent on Beijing’s actions. “A more credible and sustainable policy stance and reform drive” will bolster confidence .

Looking in detail at local government debt, which had reached $3 trillion by the end of last year, S&P says that while China is making incremental steps to reduce it, off-budget borrowing is unlikely to be curtailed sufficiently in the short term without fresh “fundamental fiscal reforms that correct the structural imbalance between local government revenues and spending.”

President Xi Jinping pronounced earlier this year that local officials would themselves be made responsible for taking on new unsustainable debt. But there has been no indication since then or whether or how this sanction might be applied.