How Long Can China Defy the Laws of Macrofinancial Gravitation?

The International Monetary Fund has warned that China’s debt is approaching “dangerous” levels. The Fund expects China’s non-financial sector debt to exceed 290 per cent of GDP by 2022, compared with 235 per cent last year. How long can China’s debt binge last? Recent research by economists at the Bank of International Settlements suggests not long.

Drehmann, Juselius and Korinek (2017) have emphasized the role played by debt service burdens in puncturing credit booms. There is an interesting lead-lag structure between new lending and debt service burdens. New lending mechanically increases the debt service burden, but the weight is felt with a lag.

When taking on new debt, borrowers commit to a pre-specified path of future debt service. This implies a predictable lag between credit booms and peaks in debt service which, in a panel of household debt in 17 countries, is four years on average.…Debt service peaks at a well-specified interval after the peak in new borrowing.…The reason is that debt service is a function of the stock of debt outstanding, which continues to grow even after the peak in new borrowing. 

Credit booms have a clear mechanical path. An exogenous increase in the risk-bearing capacity of the financial sector drives a lending boom. Credit-to-GDP ratios rise. Debt service ratios follow. At some point, debt service becomes too onerous to sustain, the lending boom is arrested and a financial crisis breaks out.

We illustrate these dynamics with the US experience. Figure 1 plots the detrended Credit-to-GDP gap and the Debt Service Ratio for the US private nonfinancial sector. We see that the credit gap peaked at 12.4 and the debt service ratio peaked at 18.4 just as the Great Recession began in the last quarter of 2007. The denouement of the credit boom triggered the onset of the Global Financial Crisis (GFC) as credit defaults made their way to dealer balance sheets.

Figure 1. US private nonfinancial debt service ratio and credit gap.


Figure 2 plots the Chinese nonfinancial sector’s credit gap and debt service ratio. As of 2016Q4, China’s credit gap was an astounding 24.6; twice as high as the peak American gap of 12.4. And China’s debt service ratio was 20.1 as of 2016Q4, already larger than America’s peak ratio of 18.4.

Figure 2. Chinese nonfinancial sector’s credit-to-GDP gap and debt service ratio.

The importance of these indicators comes from the fact that they are the strongest predictors of financial crises. In particular, the BIS researchers quoted above have shown that positive shocks to the debt service ratio significantly increase the probability of a financial crisis over the near term (1-3 years). They find that “debt service is the main channel through which new borrowing affects the probability of financial crises.”

Figure 3. Nonfinancial private debt service ratios in the United States and China.

Figure 3 displays the debt service ratios of the United States and China for 1999Q4-2016Q4. Since then the Chinese government has pushed through yet another credit expansion (which is what prompted the scolding from the IMF). It is hard to escape the conclusion that Beijing would find it hard to achieve a soft landing.

Mechanically, we know what will happen soon. A correction in property prices will destabilize the $28 trillion shadow banking flywheel built on top of real estate. Whether or not it leads to a dramatic implosion would depend on the strategy pursued by Beijing. Xi is definitely sold on Geithner’s financial Powell doctrine. But whether the crisis can be contained with techniques of financial fire-fighting that have evolved since 2007 remains to be seen. What is certain is that Beijing would have to absorb a significant portion of private liabilities onto the national balance sheet. As a result, public debt is likely to balloon.


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