Global Financial Crisis and the Rise of Global Debts

 

Over the past decades, global debt has been growing among corporate borrowers, governments, households and financial institutions.  

 

Professor Charles Goodhart at the London School of Economics attributes the swelling debts to three factors since 1970s: the increase in global savings relative to investment, the willingness of the financial sector to lend, and the demand for safe assets. According to him, favourable demographics in the past 40 years have created a global savings glut causing real interest rates to fall. A substantial portion of these savings, belonging to emerging economies, were parked as official reserves in advanced countries where the banks’ then extended credit at lower interest rates. The cheap money encouraged consumption and speculative activity rather than investments in long-term productive projects. In the end, the speculations created inflated asset bubbles which eventually evolved into crisis which prompted governments to inject even more liquidity into the system by creating more debts.

 

Take the last Global Financial Crisis (GFC) of 2008-2009, for instance. Global debt rose to more than $200 trillion, or $27,000 for each person in the world when governments around the world implemented measures to address the liquidity crunch in the immediate aftermath of the crisis. In the years that followed, in their haste to prevent a downward spiral of real economy due to credit crunch, central bankers flooded the markets with even more short-term liquidity through quantitative easing and negative interest rates. The flood of cheap liquidity caused debts around the world to spike. By 2015, global debt of households, non-financial corporates and the government – so called non-financial debt – had risen to 233% of GDP from 212% prior to the GFC.[1] By the end of 2017, worldwide debt had reached a record $237 trillion, according to the Institute of International Finance (IIF).

 

The monetary measures prevented the crisis from worsening but they also helped politicians to put off structural reforms. Instead of finding ways to bring down the level of debts, governments, banks and companies rolled over old debts by creating more new debts.[2] The result was slower growth from declining productivity, even as borrowing continued for companies and governments which had become addicted to easy borrowing rather than adopting tough reforms. In short, the world has sunken into a debt trap.

 

Economic Risks Associated with Emerging Market Economies’ High Corporate Debts

 

Notably, even though most of the debts are in advanced economies, most of the increase in the debt ratio took place among the emerging market economies (EMEs). In the advanced economies where the increase is more modest, the build-up has been mostly driven by government debt. In the case of the EMEs, the non-financial corporates, particularly in the mining, energy, construction (materials) and real estate sectors, were mainly responsible for the new debts. Since 2008, their total borrowings have risen by a staggering $15 trillion, surpassing $24 trillion by the third quarter of 2015. The average debt-to-GDP ratio widened by 40 percentage points to over 100%, which is significantly higher than the average ratio of 86% for advanced economies. Among the EMEs with higher debts, Greater China (i.e. including Hong Kong) stands out. In fact, most of the increase in EMEs non-financial corporate debt can be attributed to China. Excluding Greater China, the increase is more modest at 12% of GDP, to some 53%.[3] In other words, the EMEs’ corporate debt ratio is skewed by China.

 

Borrowing on the current scale by EMEs’ corporate sector is risky because a downturn in corporate revenues can easily impair borrowing firms’ ability to repay. Moreover, firms in EMEs are often forced to borrow offshore due to underdevelopment of their domestic capital markets. Such debts, usually denominated in foreign currencies (mostly US dollar) carry an extra currency mismatch risk. Theoretically, the risk can be mitigated by firms hedging the foreign currency risks at the point of assuming the debts but most firms do not practice hedging in reality.  A case in point is the 1997 Asian Financial Crisis (AFC). Before the crisis, many Thailand firms were borrowing dollar debts heavily betting that Thai Baht would continue to appreciate making it easier to service the debt later. But when the country’s current account deteriorated and Baht came under attack. The Thai government defended Baht selling their reserves of foreign currencies (mostly US dollar) to buy Baht. When the foreign exchange reserves was depleted, the Thai government had no choice but to devalue its currency. Many firms soon developed difficulty as they now need more Baht to repay their dollar debts. Meanwhile, the market panic spreads through contagion and the currency of other economies within the region also came under attack by speculators. What started off as a Thai crisis soon evolved into the AFC.

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Today, the excessive debts by the EMEs have created the conditions for the making of another AFC-styled financial crisis. The situation is exacerbated by some governments’ mismanagement of their economy causing their currency to become overvalued. Moreover, as monetary policy normalizes among advanced economies, funding conditions for emerging market companies can worsen significantly making it increasingly difficult for them to roll over existing debt or raise new debts. This, along with the current Sino-US tariffs war and the threat of slowing world trade, could disrupt global momentum as business confidence and investment plunge.

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The Bank of International Settlements (BIS), in particular, views China as among those most vulnerable to a banking crisis today because of the size of China’s debt and the speed of its debt expansion.

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Evolution of China’s Domestic Debts Since its Opening Up

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Briefly, China’s history of national debt has gone through the following phases:[4]

• Debt increase lower than GDP growth (1980s – 2004) :  Deng’s economic reforms began first with the rural agricultural sector. As agricultural yield and household income rose, farmers began to diversify their activities. Some started their own small private business while others formed collective enterprises known as Township and Village Enterprises (TVEs) with the support of local government. By the 1980s, SOEs began to face rising competition from these TVEs and small private firms which were many efficient. Many SOEs became unprofitable but were kept on life support by the state banks because the SOEs played important social functions of providing jobs and welfare. By the 1990s, the state banks were plagued by problem of non-performing loans made to the SOEs. The problem, however, was kept under lid by the rapidly expanding economy and by the fact that the lenders were state banks. To tackle the bad debts, Premier Zhu Rongji first embarked on SOEs reforms through his zhuada fangxiao (抓大放小 Holding on to the big SOEs, letting go of the small) initiative to ‘stop the bleeding’. At the same time, asset management companies were set up to take over the non-performing bank loans. After the banks were cleaned up and recapitalized, foreign investors were invited to hold a stake in the state banks to improve on the management of the banks. Notably, much of the debts raised during this phase was invested in the manufacturing sector and in basic infrastructures which over time contributed to the impressive and robust double-digit GDP growth.

• Debt and GDP growth were basically synchronized (2004 – 2008) : In this period, GDP growth was at a stable and similar pace as the debt increase, which shows that debt had its positive function on economic activities. Industrial capacity expanded rapidly also as a result of an influx of FDI. As a result of rapid pace of industrial investments by debts and by foreign capital inflows, Chinese economy expanded quickly and China became the “factory of the world”. Much of the growth, however, was still low value-add. In an attempt to move up the value-add ladder, the Hu-Wen government began efforts in 2006 to restructure the economy.

• Debt increase higher than economic growth (2008 – 2015) : Chinese government implemented the 4 trillion yuan stimulus in the aftermath of the GFC. 60% of the plan stimulus was in the form of bank loans which were dispensed mostly to the SOEs and local governments. Private sectors firms, particularly the SMEs, were deprived of loans to expand because the state banks preferred to lend to SOEs and local governments which were seen as safer borrowers backed by implicit state guarantees. Many SMEs turned to underground banking paying exorbitant interest rates. Local governments also began amassing borrowings through financing vehicles while banks practiced off-balance sheet shadow banking. Both SOEs and local government exploited their privileged access to cheap capital and maximized their borrowing. Debt exploded during this phase. According to Goldman Sachs, China’s debt buildup since the GFC has been one of the largest in modern history.[5] To prevent hard-landing of the economy, critical reforms that could have helped to restructure the economy were delayed by the Hu-Wen government. Economy began to slow because of excess capacity and the sluggish external economy. Returns from industrial investments began to shrink. When the excess liquidity was diverted into more lucrative speculative property investments, housing prices spiked. Household sector borrowings also began to hike because of rising mortgage loans. Consumer financing also surged with the proliferation of non-bank financial institutions brought about by the deregulation of the market in 2014. Overall, there were wasteful resource allocation and increasing financial fragility. Investment in this period is more on infrastructure than manufacturing.

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In 2015, Xi launched his supply-side reforms and began developing the domestic debt market to reduce the systemic risks caused by overdependence on the banking sector. In 2016, the government began to clamp down on shadow banking and to rein in excessive borrowing by SOEs and local governments. Despite its government’s strong deleveraging efforts, however, China’s debt continues to build up. By the end of 2017, the Chinese total debt-to-GDP rose to an estimated of 317% (or 282% if financial sector debts are excluded, compared with 158% at the end of 2008).[6] As for speed of its debt expansion, while its nominal GDP expanded 11.2% in 2017, credit grew by a faster 13.5%, although down from the 18.0% during 2016. In other words, even though debt growth had slowed in 2017, the rate was still faster than that of nominal economic growth.

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Hence, up till 2015, China's domestic debt is predominantly lending from domestic banks to especially the state sector comprising SOEs and local governments. After 2015, however, the Xi-Li government has begun to progressively shift borrowings from banks to domestic debt market.

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Rise of China's External Debt

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To be sure, until the late 1970s, China had almost no external debt because of Mao’s autarkic policy of “self-reliance”. Restrictions on external borrowing were very tight. China’s experience with external debt really began to accumulate only after its opening up to the world under the leadership of Deng Xiaoping in 1979 when China needed financing for machinery and materials for the development of its economy.

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After 2014, Another trend that emerged particularly after 2014 is the rapid rise of China’s foreign debt. As can be seen from the graph, China's foreign debts spiked after 2014 as the Chinese government launched its supply-side reforms and the deleveraging efforts.