Crisis Or Stagnation: Why China Cannot Deleverage

The latest figures of the Chinese economy show a third-quarter GDP growth of 6.8%, suspiciously in line with the government mandate and consensus estimates. However, it is not the top line that worries me. It is the evidence of debt saturation and diminishing returns of the central-planned model.

Chinese total debt has surpassed 300%. In the first nine months of the year, the money supply has increased by 9.2%, significantly above estimates.

China has added more debt in the first nine months of 2017 than the US, Japan and the EU combined.


The private sector debt increase is a major concern. The vast majority of the largest quoted companies (c60% of the Hang Seng Index) have published results with returns significantly below their cost of capital, looking at Bloomberg figures. According to the Financial Times, zombie firms have soared as growth fails to catch up debt and interest increases. Additionally, in a situation that mirrors the reckless international buying spree of European conglomerates in the early 2000s, the results of foreign capital investments at ludicrously high multiples have generated a backlash for Chinese multinationals. The central government’s legion of zombie firms (those unable to cover interest expense with operating profits), is comprised of 2,041 large companies with assets worth some $450bn.

The concerns over the mountain of debt is only comparable to the atrocious returns in a fast-growing economy. A glance at the Hang Seng Index shows a leverage of 122% (total debt to equity) and 17.5x debt to assets, with an abysmal return on assets of 1.33% and return on capital of 4.5%.

It does not improve significantly by sectors. Even if we look at what has been optimistically called “new economy”, Chinese companies boost a similar combination of weak fundamentals and poor capital allocation. The “new economy”, driven by high productivity sectors, is heavily dependent on strong capital markets in order to finance growth via bonds and equities. A surprisingly low non-performing loan ratio of 1.74% is widely questioned, and Fitch, for example, estimates that the real figure is ten times greater than the official one. A weaker stock market and contagion effect of rising non-performing loans impacts the weak and obsolete dinosaurs and the nascent, thriving sectors alike. We saw it in Taiwan, Japan, and the EU.

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