Rating a rare Chinese credit warning

FT.com

It would be easy to dismiss China's first downgrade by an international rating agency since 1999 as unjustified pessimism. At less than 20 per cent of national income, China’s official debt stock is tiny. Growth, albeit slowing, remains healthy. In any case, Beijing is not short of options to repay its debt, whether via its central bank’s printing press or by increasing taxes that are still low.

Yet the report that accompanies Fitch’s decision to lower Beijing’s rating from AA- to A is right to emphasise China’s rapid expansion of credit as a real threat to economic stability. There are two areas of immediate concern. First, the size of the debt mountain accumulated by local authorities. Second, the stability of China's growing shadow banking sector.

China’s municipalities have been saddled with loans since 2009, when Beijing encouraged its provinces to go on an investment binge as part of a heroic stimulus package. Roughly a quarter of these projects generated no revenue. The debt stock for local governments, unconsolidated in the public debt figures, is more than 10 trillion renminbi ($1.6 trillion), a fifth of national income. Much of it is in short-term bank debt, placed in special-purpose investment vehicles designed to circumvent a ban on borrowing.

So far, Beijing has dealt with this problem by demanding that state-owned banks roll over these debts. But this is only a palliative. The government’s push for municipalities to issue their own bonds is more promising, as it will encourage greater thrift and transparency. Yet, ultimately, Beijing will have to decide whether it intends to bail out its provinces, which would add to its own debt stock.

Just as worrying is the rise of China’s shadow banking, which is financing almost half of all new credit. True, the development of shadow banks is natural as a financial system becomes more sophisticated. Yet the products sold outside China’s formal lending sector are often murky. Too frequently, they are used to finance uncreditworthy projects, particularly in the property industry. The authorities are seeking to regulate the sector by demanding greater disclosure. Critics fear these steps will prove insufficient.

Beijing faces a dilemma: regulating fast-expanding credit flows is bound to constrain growth. But the alternative is much uglier. As the western experience of the past decade shows, economic development is real only when it is financially sustainable. Getting a grip on credit expansion should be a priority for China’s leadership.

Copyright The Financial Times Limited 2013