Leading Independent Investment Research, Morningstar, Inc.

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Leading Independent Investment Research

Morningstar, Inc.

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<div class="content-highlight"><h2>The ugly dynamics around a rising debt/GDP ratio threaten China's financial system.</h2></div><hr><p>The rapid expansion in China's debt/GDP ratio has raised concerns among many observers, including us, because it is reminiscent of prior credit booms that have ended badly. Having watched Beijing repeatedly stimulate its way to higher growth, investors ask why this can't continue. Bluntly, if credit continues to outpace GDP growth significantly, we expect one of two scenarios to eventually occur.</p><p>The first scenario is a full-blown credit crisis. Here, we'd see credit availability sharply contract, leading to a decline in investment spending. Overall economic activity would then slow amid a wave of borrower defaults. As the bad debt is recognized and written off by banks, lending growth can resume, helping the economy return to growth.</p><p>The second scenario is persistently weak economic growth. In this scenario, we'd see a rising share of credit continue to flow to "zombie" state-owned enterprises and local governments and debt rolled over at banks, papering over losses. In turn, less credit would be available to private companies, which have been very productive and generated higher returns on equity than SOEs. With less credit flowing to productive investment, the credit returns continue to falter, leading to lower levels of productivity as more-productive sectors are starved of credit.</p><hr><h2>Key Takeaways</h2><ul><li>Thailand, Malaysia, Japan, and Korea have all experienced similarly rapid credit booms that ended in painful deleveraging episodes, which caused real GDP growth to fall about 50% from boom-era levels. The International Monetary Fund has noted that in prior instances when the credit/GDP ratio increased more than 30 percentage points in five years, 38 out of 43 economies experienced a crisis or a sharp slowdown in growth.</li><li>It is not the absolute level of debt in China that is destabilizing, but the growth in debt. The debt service ratio and credit/GDP gap have been sending danger signals for some time.</li><li>We expect returns to continue to deteriorate until Beijing becomes serious about making the needed reforms, which include eliminating hard GDP targets and soft budget constraints on the state-owned enterprises. This would also include eliminating provincial growth targets and local governments focusing on only approving projects with sustainable long-term positive returns. Ultimately, the continued increases in credit intensity, lower returns on capital, and gradually weaker SOE performance will make it harder and harder to sustain and meet GDP growth targets of 6.5%-7% annually.</li></ul><hr><p><em>Analysts: Stephen Ellis and the China Economic Committee</em></p>

The ugly dynamics around a rising debt/GDP ratio threaten China's financial system.The rapid expansion in China's debt/GDP ratio has raised concerns among many observers, including us, because it is reminiscent of prior credit booms that have ended badly. Having watched Beijing repeatedly stimulate its way to higher growth, investors ask why this can't continue. Bluntly, if credit continues to outpace GDP growth significantly, we expect one of two scenarios to eventually occur.The first scenario is a full-blown credit crisis. Here, we'd see credit availability sharply contract, leading to a decline in investment spending. Overall economic activity would then slow amid a wave of borrower defaults. As the bad debt is recognized and written off by banks, lending growth can resume, helping the economy return to growth.The second scenario is persistently weak economic growth. In this scenario, we'd see a rising share of credit continue to flow to "zombie" state-owned enterprises and local governments and debt rolled over at banks, papering over losses. In turn, less credit would be available to private companies, which have been very productive and generated higher returns on equity than SOEs. With less credit flowing to productive investment, the credit returns continue to falter, leading to lower levels of productivity as more-productive sectors are starved of credit.Key TakeawaysThailand, Malaysia, Japan, and Korea have all experienced similarly rapid credit booms that ended in painful deleveraging episodes, which caused real GDP growth to fall about 50% from boom-era levels. The International Monetary Fund has noted that in prior instances when the credit/GDP ratio increased more than 30 percentage points in five years, 38 out of 43 economies experienced a crisis or a sharp slowdown in growth.It is not the absolute level of debt in China that is destabilizing, but the growth in debt. The debt service ratio and credit/GDP gap have been sending danger signals for some time.We expect returns to continue to deteriorate until Beijing becomes serious about making the needed reforms, which include eliminating hard GDP targets and soft budget constraints on the state-owned enterprises. This would also include eliminating provincial growth targets and local governments focusing on only approving projects with sustainable long-term positive returns. Ultimately, the continued increases in credit intensity, lower returns on capital, and gradually weaker SOE performance will make it harder and harder to sustain and meet GDP growth targets of 6.5%-7% annually.Analysts: Stephen Ellis and the China Economic Committee

China's Debt, Part 1: The Consequences of Bingeing on Debt