China faces delicate balance between debt and growth: S&P

How concerning is China's debt picture?

China's economic transition has caused a problem for the government—how to avert a sharp slowdown while keeping a lid on ballooning debt.

In a report Thursday, rating agency Standard and Poor's highlighted the "tough choice between supporting growth and controlling debt sustainability" as China tries to find new ways to fund public investments.

"Although aggregate and provincial GDP growth stabilized in the first two quarters of 2016, we believe the fiscal conditions of Chinese local governments are under more pressure given the weakened economy," S&P analysts wrote in a report.

The rising debt pile of local government financing vehicles (LGFV) raised questions on credit risks, said S&P.

"As long as investments remain a growth impetus, it is very hard to shift away from the old public financing model to weaken the LGFVs' role in public investment," said S&P credit analyst, Xin Liu.

"The growing pile of LGFV debt will add to the fiscal vulnerability of local governments, which already rely on these financing vehicles to execute public investment mandates," she added.

S&P's warning on local government debt comes amid concerns about overall debt levels in the country as the world's second-largest economy begins to slow after years of boisterous growth.

China's debt load is worrying investors and observers.
STR | AFP | Getty Images

Corporate debt is also under focus.

In another report released on Tuesday, S&P warned that the "unabated growth" of China's corporate debt could cost the country's bank "dearly".

It said the current growth rate of China's debt "is not sustainable for long".

S&P said if the growth in debt doesn't slow, the ratio of problem credit to total credit facing China's banks could triple to 17 percent by 2020. The banks may then need to raise fresh capital of up to 11.3 trillion Chinese yuan ($1.7 trillion), which is equivalent to 16 percent of China's 2015 nominal GDP.

The Bank of International Settlements warned recently excessive credit growth in China will increase the country's risk of a banking crisis in the next three years.

Good news for China's debt reform?

To cope with the debt load, China unveiled guidelines on Monday to reduce rising corporate debt.The government said it will take a multi-pronged approach to cutting company debt with measures including encouraging mergers and acquisitions, bankruptcies, debt-to-equity swaps and debt securitization, according to guidelines issued by State Council.

Corporate China sits on $18 trillion in debt, equivalent to about 169 percent of gross domestic product (GDP), according to Reuters.

China will combine deleveraging with overcapacity reductions, with the government giving preferential tax treatment to help firms cut debt levels, officials said on Monday, the news agency reported.

According to a recent Reuters analysis, profits at roughly a quarter of Chinese companies were too low in the first half of this year to cover their debt servicing obligations.

"We believe China's banks and financial system can withstand higher non-performers. However, in the downside scenario where the current growth rate continues unabated over the next five years, the likely rise in nonperforming debt could place greater strain on the financial sector, possibly leading to some bank recapitalization," said Qiang Liao, a S&P credit analyst wrote in Tuesday's report.

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