#china – Chris Mallin Macro Perspectives

“Putting the China balance sheet recession story on hold?”

At least for the time being…

The key chart

HH debt ratios (% GDP, y-axis) plotted against NFC debt ratios (% GDP, x-axis) for selected BIS reporting economies with high private sector debt levels (Source: BIS; CMMP)

The key message

The latest BIS data release (18 September 2023) provides another example of how China stands out among relatively indebted, global economies. In contrast to developments elsewhere, the debt ratios of both the corporate (NFC) sector and, to a much lesser extent, the household (HH) sector rose between 1Q22 and 1Q23 – putting the idea of a balance sheet recession on hold, at least for the time being.

In 1Q23, China’s private sector debt ratio hit a new high of 227% GDP. This is the same level reached at the peak of Spain’s debt bubble in 2Q10 and 13ppt higher than Japan’s peak back in 4Q94. As noted before, the level of bank credit to GDP is much higher in China than in other “bubble phases”, leaving the country’s banks relatively exposed to the risks of private sector indebtedness.

Affordability risks also hit a new high, with China’s private sector debt service ratio reaching 21.3%, 5.5ppt above its long-term average. China’s private sector is unique among BIS reporting economies in terms of recording a new debt service ratio high in 1Q23, although the same is also true for the HH debt service ratios in Canada, Korea and Sweden.

With growth slowing, China appears to be reverting to higher levels of corporate credit as a solution, at least in the short term. The risks associated with this familiar strategy remain high. If successful, however, it would represent a unique chapter in the history of global debt dynamics.

Putting the China balance sheet recession story on hold?

The chart below illustrates HH debt ratios plotted against NFC debt ratios for the BIS reporting nations with the highest levels of private sector indebtedness for 1Q22 and 1Q23 (excluding Hong Kong and Luxembourg).

HH debt ratios (% GDP, y-axis) plotted against NFC debt ratios (% GDP, x-axis) for selected BIS reporting economies with high private sector debt levels (Source: BIS; CMMP)

As can be seen, China and, to a much lesser extent Japan, stands out due to the fact that both debt ratios rose over the period.

In China’s case, the NFC debt ratio rose from 156% GDP to 165% GDP over the period while the HH debt ratio rose very slightly from 61% GDP to 62% GDP. In Japan, the NFC debt ratio rose from 67.9% GDP to 68.1% GDP while the HH debt ratio rose from 116.5% GDP to 117.1% GDP – marginal changes.

NFC debt ratios also rose in Korea and Denmark but the more common trend was for both ratios to fall over the period – see Switzerland, Sweden, France, Canada, the Netherlands, Norway and Belgium (in chart above).

These trends put the China balance sheet recession story on hold, at least for the time being. But, note…

Trends in Japanese, Spanish and Chinese private sector debt ratios (Source: BIS; CMMP)

The chart above (one of my favourites since 2017) illustrates trends in private sector debt ratios for Japan, Spain and China since 1981. In 1Q23, China’s private sector debt ratio hit a new high of 227% GDP. This is the same level reached at the peak of Spain’s debt bubble in 2Q10 and 13ppt higher than Japan’s peak back in 4Q94.

Trends in Japanese, Spanish and Chinese bank credit to debt ratios (Source: BIS; CMMP)

As noted before, the level of bank credit to GDP is much higher in China than in other “bubble phases”, leaving the country’s banks relatively exposed (see chart above). At the end of 1Q23, China’s bank credit to GDP ratio hit a new high of 192% GDP, well in excess of the peaks recorded in Spain (168% GDP, 2Q10) and Japan (117% GDP, 1Q90).

Trend in China’s private sector debt service ratio since 1999 (Source: BIS, CMMP)

Affordability risks also hit a new high, with a debt service ratio of 21.3%, 5.5ppt above its long-term average of 15.8% (see chart above). Note that China’s private sector is unique among BIS reporting nations in terms of the DSR being at a peak level, although the debt service ratios of the HH sectors in Canada, Korea and Sweden are also at new highs too.

Conclusion

Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.

“Why is Richard Koo’s profile rising in China?”

Because the Chinese government knows there is a disease called “balance sheet recession”.

The key chart

Trends in “excess credit growth” in China since December 2012 (Source: BIS; CMMP)

The key message

“The Chinese government knows that there is a disease called balance sheet recession, and they should know how to handle it”
Richard Koo, quoted by Bloomberg on 10 July 2023

Richard Koo is the Chief Economist at the Nomura Research Institute who developed the concept of “balance sheet recessions”. These recessions occur when “a nationwide asset bubble financed by debt bursts” (Koo, 2008). According to a Bloomberg article this week, “Koo’s ideas are being taken seriously in China”.

In this post, I explain why this is the case. I revisit my January 2023 arguments and update the data points and charts from “The missing link in the China re-opening story?”. I begin with the same question that I posed at the start of the year:

What happens if rather than seeking to maximise profit/utility as traditional economics assumes, the Chinese private sector (PS) turns to minimising debt or maximising savings instead? What if China experiences a balance sheet recession?

What does the data tell us?

While China’s PS indebtedness has declined from its 3Q20 peak, it remains above Japan’s “peak-bubble” level. Affordability risks remain elevated in China too. The PS debt ratio is not only high in absolute terms, but it is also elevated in relation to its long-term average. Chinese debt dynamics have shifted from excess growth in corporate credit growth, through excess growth in household debt, to a “passive deleveraging” phase. The risk remains that this extends to full PS debt minimisation i.e., a balance sheet recession.

Following recent re-intermediation, the Chinese banking sector is relatively exposed to the risks associated with these dynamics. The bank sector debt ratio exceeds the level reached at the height of the Spanish private sector debt bubble, for example, and is currently the highest ratio among BIS reporting economies.

What are the implications?

China’s debt dynamics point to potential demand (debt minimisation) and supply side (bank sector debt) constraints to future consumption.

From a policy perspective, Koo argues that the Chinese government must ramp up spending to offset private sector deleveraging. According to Bloomberg, he recommends a fresh wave of fiscal stimulus, targeted towards the real estate sector.

From an investment perspective, these factors need to be included in the investment narrative. It was a mistake to ignore private sector debt dynamics at the start of the year. It is a mistake to ignore them now…

Why is Richard Koo’s profile rising in China?

Personal background

I met Richard Koo in Tokyo when I was a graduate trainee at Nomura Securities in 1986. I left Nomura in 1988 to build the top-rated Japanese equities team (for European clients) at Baring Securities. I subsequently moved on from Japanese equities in the early 1990s to develop a career in banks research and macro strategy. I continued to follow Koo’s work, read his books and applied his approaches to my own analysis of monetary and macro developments in other advanced and emerging economies. We share a common analytical foundation based on a sector-balances framework.

My January 2023 message

In January 2023, I questioned the so-called “China re-opening” narrative. My scepticism centred on the level of Chinese private sector debt, the growth in HH debt and the affordability of private sector debt.

I asked, “What happens, for example, if rather than seeking to maximise profit/utility as traditional economics assumes, the Chinese private sector turns to minimising debt or maximising savings instead? What if China experiences a balance sheet recession?”

The July 2023 update

Trends in Japanese, Spanish and Chinese PS debt ratios since 1980 (Source: BIS; CMMP)

China’s private sector indebtedness exceeds the “peak-bubble” level seen in Japan in 4Q94. The private sector debt ratio was 220% GDP at the end of 4Q22, below its recent 225% peak but still above Japan’s peak debt ratio of 214% GDP. Note the similarity in debt ratio trends in Japan (debt bubble), Spain (debt bubble) and in China (see chart above). History rhymes…

Trend in the Chinese PS debt service ratio since 2000 (Source: BIS; CMMP)

Private sector affordability risks remain elevated too. The private sector debt service ratio (PS DSR) is not only elevated in absolute terms (20.6%) but it is also elevated in relation to its long-term average (15.7%). The PS DSR peaked in 3Q20 (see chart above) and has trended between 20-21% since then.

Trends in stock of HH and NFC debt (RMB tr) and PS debt ratio (% GDP, RHS) (Source: BIS; CMMP)

The Chinese private sector has already entered a period of passive deleveraging (see chart above). In other words, while to outstanding stock of debt continues to increase, it has been growing at a slower pace than nominal GDP since 3Q20.

Chinese debt dynamics have shifted from excess growth in corporate debt to excess credit growth in household debt and then to passive deleveraging. The risks remain that these trends extend to an extended period of private sector debt minimisation – i.e., a balance sheet recession.

Bank credit as a percentage of total PS credit (%) since 2007 (Source: BIS; CMMP)

With recent re-intermediation (see chart above), the Chinese banking sector is relatively exposed to the risks associated with current debt dynamics. The bank sector debt ratio (see chart below) exceeds the level reached at the height of the Spanish private sector debt bubble, for example, and is currently the highest ratio among BIS reporting economies (excluding Hong Kong).

Trends in Japanese, Spanish and Chinese bank sector debt ratios (% GDP) (Source: BIS; CMMP)

Conclusion

China’s debt dynamics point to potential demand (debt minimisation) and supply side (bank sector debt) constraints to future consumption.

Please note that the summary comments and charts above are extracts from more detailed analysis that is available separately.

“Update required – Part IVb”

Seven reasons why China dominates global debt dynamics (in charts)

The key chart

**Trends in private sector credit (US$ tr)**
(Source: BIS; CMMP)

The key message

In this final “Update required” post, I consider China’s private sector dynamics (post-2Q16) and the exposure of the banking sector to these dynamics (see, “Update required – Part III”). I highlight seven reasons why China dominates global debt dynamics today and illustrate them graphically.

China has the largest outstanding stock of private sector debt globally ($39tr)
China’s market share of private sector debt has increased to 27% from 20% in 2Q16 (and only 6% in 2Q08)
In the process, China has eclipsed the “EM-debt” story – the share of EM ex-China has remained unchanged over the period
China’s debt dynamic has shifted from excess growth in corporate debt (well-known) to excess growth in household debt (less well-known)
The fact that the rate of growth matters, not just its level, is the first important lesson here
The second is that affordability matters – China’s private sector debt service ratio is elevated in absolute terms and against historical trends
With recent re-intermediation, the banking sector is relatively exposed to the risks associated with current debt dynamics. Bank sector debt ratios exceed the levels reached at the height of the Spanish private sector debt bubble, for example

Why China dominates global debt dynamics in charts

Chart 1: Size

**Top-ten BIS reporting economies ranked by stock of private sector credit (US$ tr)**
(Source: BIS; CMMP)

Chart 2: Market share

**China’s share of total private sector, corporate (NFC) and household (HH) debt (% total)**
(Source: BIS; CMMP)

Chart 3: Eclipsing the rest of EM

**Breakdown of global private sector by region (% total)**
(Source: BIS; CMMP)

Chart 4: Shifting debt dynamics

**Trends in relative growth factors – 3Y CAGR in PSC versus 3Y CAGR in GDP**
(Source: BIS; CMMP)

Chart 5: Rising affordability risks

**Selected debt service ratios – deviation from 10Y average (ppt) plotted against 2Q22 level (%)** (Source: BIS; CMMP)

Chart 6: Re-intermediation…

**Bank credit as %age of total private sector credit**
(Source: BIS; CMMP)

Chart 7: How exposed is the banking sector?

**Comparison of PS and bank sector debt ratios – Spain versus China**
(Source: BIS; CMMP)

Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.

“Three key aspects – reinforced!”

China data reinforces three key aspects of global debt dynamics

The key chart

**The chart from 2019 – China’s HH credit growth outstripping GDP growth despite the fact that the HH debt ratio was close to the average for all BIS reporting countries** (Source: BIS; CMMP)

The key message

This week’s news of weaker-than-expected economic growth in China and on-going challenges in the country’s property sector reinforces three key aspects of global debt dynamics:

Conventional macro thinking is flawed to the extent that it typically ignores the risks associated with private debt (while seeing government debt as a problem)
The “EM-debt” story has, for some time, been replaced by the “China-debt” story – strip out China and EM’s share of global debt is largely unchanged since the GFC
The level of any country’s debt needs to be considered in relation to its rate of growth (and its affordability and structure).

In an early 2019 CMMP Analysis report (“Too much, too soon?“), I concluded that:

“The risks associated with excess HH credit growth in China remain elevated and this analysis presents a relatively extreme example of the importance of considering the level of debt together with its rate of growth. History suggests that current trends in China are unsustainable. The most benign outcome is that the rate of growth in HH borrowing slows more rapidly with negative implications for consumption and aggregate demand. In short, China’s increasing HH debt burden represents a key headwind in the transition to a consumption-driven economy.”

Debt dynamics matter, a lot, but conventional approaches to understanding them need updating.