Why China's Debt Is a Problem

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After China's economic growth eased to its slowest pace in over a decade last year, concerns about the country's future have begun to multiply.

Of particular concern is China's hidden debt risk, which hints that the Chinese government may be liable for a lot more than its official balance sheet would suggest.

Since 2008, the nation's government-owned banks have embarked on a lending spree of massive proportions. Much of the credit has been directed toward state-owned enterprises, or SOEs, and local governments, who've used it to dabble in property and infrastructure projects, many of which are unlikely to generate the cash flows necessary to repay the debt.

As these and other concerns mount, a growing number of commentators are suggesting that a debt crisis in China may not be far off.

China has debt problems? Really?
At first glance, the suggestion that China could be engulfed by a debt crisis seems counterintuitive, perhaps outright silly. After all, the Chinese are one of our biggest creditors -- holding $1.26 trillion in U.S. Treasuries as of January 2013 -- and possess the world's largest foreign exchange reserves.

To understand why China's debt could quickly get out of control, it's helpful to understand how its economy has grown over the past few decades. China's growth model is one driven primarily by government-influenced investment and -- to a much lesser extent over recent years -- exports of mainly manufactured goods. The third, and weakest, engine of growth is domestic consumption, whose share as a percentage of GDP remains astoundingly low for an economy as large as China's.

As Professor Michael Pettis has repeatedly warned, countries that have relied on this type of growth model in the past almost always run into the same problems -- malinvestment during the boom years and a rapid buildup of debt during the downturn. When the model eventually, and inevitably, runs out of steam, debts tend to rise rapidly and often become unmanageable.

Patrick Chovanec, chief strategist at Silvercrest Asset Management and a former professor at Beijing's Tsinghua University, explains:

With the lending boom that took place in China in the last three or four years, it was fiscal spending in disguise, and now the bill is coming due. Once the fiscal taps are open, the money released will go to pay for the growth of the past four years, not the next quarter, not the next year, not the next decade. You start to see that already, with the bailouts starting to take place in China -- local governments, even the national government, devoting resources to bailing out property developers, bailing out state-owned enterprises, bailing out companies that have run into trouble, bailing out local governments.

In other words, China's attempt to supercharge its growth after 2008 through a massive government stimulus package, though arguably successful at first glance, also led to a rapid buildup of debt among Chinese corporations, local governments, and other entities.

Struggling solar companies
Take the nation's solar companies, for instance, which have racked up alarming amounts of debt since 2009. At Yingli Green Energy (NYSE: YGE  ) , the third-largest solar-panel manufacturer in the world, outstanding short-term debt nearly tripled from 2009 to 2011, while profits have collapsed.

Unlike their peers in the U.S. and Germany, Chinese solar companies receive strong support from domestic banks and local governments, many of which depend on them to generate tax revenues, employment, and growth.

But as conditions in the global solar industry have deteriorated, prospects of timely repayment look increasingly doubtful. After years of extending lifeline after lifeline to these struggling companies, it looks like some Chinese lenders have had enough.

For instance, LDK Solar's (NASDAQOTH: LDKYQ  ) creditors are currently "in talks" with the company's host local government over debt payback. The solar company's local government -- the Xinyu government, in central China's Jiangxi Province -- has been urging various companies to take LDK off its hands, but there has so far been little interest, according to a source with knowledge of the matter, says CaixinOnline.

And then there's Suntech (NASDAQOTH: STPFQ  ) . After it missed a payment on $541 million of convertible bonds on March 15, its creditors sued the struggling solar-panel maker three days later. The firm was subsequently declared bankrupt and is currently undergoing debt restructuring.

Final thoughts
The trials and tribulations of China's solar industry are just the tip of the iceberg. They merely highlight the unhealthy addiction to debt financing that China's corporations have developed in recent years. Last year, total debt among China's corporations surged to 122% of GDP, the highest level in 15 years, according to GK Dragonomics, a China-focused research firm.

Another important facet of China's corporate indebtedness is that many debt-laden companies are government-owned, as are the banks that lend to them. In fact, one of the most fascinating aspects of China's unique system of state-led capitalism is that the nation's four major commercial banks are state-owned.

This has allowed China's government to unleash tidal waves of credit to counter economic slowdown. But the downside is that, if those loans go bad, as I suspect many likely will, the Chinese government may end up having to foot the bill. Whether or not it finds itself able and willing to do so remains to be seen.

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Read/Post Comments (4) | Recommend This Article (12)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 01, 2013, at 5:53 PM, dsong wrote:

    This article looks likely baseless.

    1. China hold US debt 1.3 tril. and has reserve 3 tril USD.

    2. China major banks does not have subprime mortgage problem in 2008. The downpayment for a house is as high as 50% - 95%.

    This is not like QE3 QE4 just print money.

  • Report this Comment On April 02, 2013, at 8:43 AM, StopPrintinMoney wrote:

    it's so much easier when you only concern yourself with other countries debt problems.

  • Report this Comment On April 02, 2013, at 8:51 PM, dodelijk wrote:

    I don't see why this article incites such disdainful comments from 2 of its readers. I personally think that the author has done a good job of bringing facts such as these into our focus. I'm from Europe and everyone here seems to be under that impression that the benefits of the benefits of the Chinese economic boom will eventually trickle "down" to Europe. Economists tend to overlook the economic condition in China with their main focus being on their own region which is understandable.

    The author is entitled to his/her own opinions and as I am to understand the author is of Sri-Lankan or Nepali origin so i doubt this article was written with any intention of defaming the Chinese economy.

  • Report this Comment On April 03, 2013, at 1:02 PM, moksha22 wrote:

    I dont think its disdain comments from the first 2 readers.

    They were just pinpointing "facts" about the chinese economy. Whereas, the author, is more on the verge of speculating than anything else.

    ne cannot assume that the china economy is being run the same way as the American or even europe.

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