China's Debt Build-Up Explained

China’s debt-load has increased rapidly since 2008 and has reached comparable levels to those carried by countries worst hit by the global financial crisis. State-owned companies and real estate developers are largely responsible for this build-up and, since it will take time to reform the state-owned sector, change lending habits and restructure the economy away from a reliance on the real estate sector, China faces a long-term debt overhang.

Cross-Country Comparison of Corporate Leverage Ratios

A recent research paper released by the Hong Kong Monetary Authority shows that China’s debt burden has reached worrying levels. Corporate leverage ratios - total debt as a share of assets - for non-financial companies in China at the end of Q2 2014 stood at approximately 0.62, approaching the levels of 0.7-0.75 held by the same kinds of companies in the US and UK directly before the global financial crisis.

Put simply, companies in real estate and overcapacity sectors - steel, coal, glass and cement - have largely driven the build up in debt holdings. This partly reflects the response of the Chinese authorities at the time of the financial crisis, when it rapidly increased financing to support the economy.

Corporate Leverage Ratios in China: Sector Comparison, 2002-2014

Source: Hong Kong Monetary Authority: Quarterly Report (Q1 2015)

Real estate is considered vital to the economy. Developers are a source of income for local governments through land sales, as well as a major consumer of steel, glass, cement and construction materials; as such, real estate companies have received priority financing from the largely state-directed banking system.

Despite overcapacity and low profitability, steel, glass, cement and other industries also receive favourable lending from the banking system because they are seen as being strategically important to the government’s industrial policy. This policy partly focuses on maintaining employment but it also channels the government’s strategy to maintain the dominance of state-owned in key sectors in the economy.

Banks in China are biased toward state-owned companies because they benefit from government support, e.g. subsidies, low tax charges and protection from competition, and have unwritten guarantees that the government would step up and protect those companies in times of economic crisis. Private companies, particularly small-and medium-sized, are often cut off from bank lending or have to pay much higher interest costs because, without expressed government support, they are seen as comparatively risky options.

Corporate Leverage Compared: SOEs and Private Sector, 2002-Q2 2014

Source: Hong Kong Monetary Authority: Quarterly Report (Q1 2015)

To mitigate against the risks associated with rapid debt expansion, China’s leaders must reform the economy so that capital can be allocated much more efficiently. While the government has taken steps to reform the financial sector, state-owned companies and real estate developers still figure heavily in aggregate loan allocations, reflecting their importance to the economy and current industrial policy. This relationship is unlikely to be broken overnight and, assuming the government wants to get serious about it, will take time to change. As such, concerns about indebtedness in China are unlikely to go away soon.