World Economy

China says it's cuttings its debts — here’s how that’s actually working

Key Points
  • China intensified its efforts in 2017 to contain financial risks after years of excessive borrowing
  • Concerns continued to mount when China's debt didn't stop growing, but experts told CNBC that deleveraging is bearing fruit

China intensified its efforts this year to contain risks coming from a long stretch of excessive borrowing, but concerns continued to mount when the country's debt didn't stop climbing.

In fact, the country's debt-to-GDP ratio grew from around 180 percent in 2011 to 255.9 percent by the second quarter of 2017, data by the Bank for International Settlements showed. Yet despite that increase, many in the global investing community are saying some concerns are overblown.

That is, risks from the world's second-largest economy have subsided as government moves to deleverage are bearing fruit, experts told CNBC. That progress will only continue after President Xi Jinping signaled greater resolve to tackle financial risks during the 19th Communist Party Congress in October, they added.

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"Everyone tends to focus on the gross amount of debt ... Although China's gross debt numbers are high, the U.S. numbers are higher still, so it's not really a fair comparison," said Andy Seaman, chief investment officer at Stratton Street.

Seaman said for a better assessment of China's wealth, one should consider the country's assets as well. China's foreign exchange reserves alone have been rising for ten straight months to $3.119 trillion in October, placing the country in a "very strong" net foreign asset position along with others such as Germany, Seaman said.

Net foreign asset refers to the total value of assets a country owns abroad, minus the value of its local assets held by foreigners. The indicator is often used as a reflection of a country's indebtedness.

Even then, China recognized that its reliance on debt to grow its economy is not sustainable and has embarked on a journey to transition the country into a more consumer-led growth model. The government has taken steps to contain the rise of risky credit and this is how it is fairing:

Rein in corporate debt

The corporate sector, in particularly the state-owned enterprises, accounts for a large majority of debt that China holds. Credit-to-GDP from non-financial companies rose from around 120 percent by the end of 2011 to the recent peak of 166.8 percent. That figure has come down to 163.4 percent in the second quarter of 2017, BIS data showed.

The slowdown in corporate credit was a result of government reforms to cut excesses in troubled industries such as steel and coal, and impose tighter restrictions on companies' overseas investments.

Data by Dealogic showed a 12 percent year-on-year decline on the number of deals announced in the first nine months of 2017. Meanwhile, Mergermarket data showed the total value of all deals over the same period was over $5 million fell more than 50 percent year-on-year.

In addition, a debt-for-equity swap program was announced in 2016 to curb the rise in corporate debt. As of Sept. 22, 77 companies in China had conducted debt-for-equity swaps worth more than 1.3 trillion yuan ($196.48 billion), Reuters reported.

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The government's efforts were also helped by a brighter economic climate in 2017, experts told CNBC.

"The global economic environment is very supportive towards the Chinese economy right now and you do need a stable and improving economy in China to achieve that objective in deleveraging," said Andrew Swan, BlackRock's head of Asian and global emerging markets equities.

"We do expect global growth to accelerate in the coming 12 months so China has got a really, really good opportunity here to improve the quality of debt in the economy," he added.

Tighter grip on local governments

Local governments were identified as a major risk to China's financial stability, partly due to their lending from the "shadow banking" sector and debt accumulated over the past years to upgrade infrastructure across the country.

Fitch Ratings has warned that the country may see its first local government default, without specifying a timeline.

Such concerns have led to Beijing tightening controls on local government finances. Besides cutting down on bond issuance, Chinese authorities are also urging local government to cut down on infrastructure spending, according to a Caixin report.

The report said two Chinese cities were asked by the government to scrape railway projects worth billions of dollars.

Households being watched

Total household debt is still small but is inching up in recent quarters. BIS data showed that household credit-to-GDP rose to 46.8 percent in the second quarter of 2017, up from 27.7 percent at the end of 2011.

The Chinese government has made taming the housing market a priority and and imposed restrictions on property sales in a number of major cities to prevent speculative activities. Beijing also suspended regulatory approval for new internet micro-lenders to clamp down on consumer loans.

Healthier finance sector

The International Monetary Fund, in a recent financial stability study on China, said the lack of inter-agency coordination in financial supervision could breed risks in the increasingly large and complex banking system.

The Asian economic giant set up the Financial Stability and Development Committee in November for better financial oversight. The banking, securities and insurance sectors were previously overseen by separate entities, which led to similar financial products being regulated differently depending on who the issuer was.

"This has encouraged a game of whack-a-mole between issuers and regulators, which would tighten controls on one industry only to see activity pick up in another," a Nikkei Asian Review report said.

ICBC Bank's ATMs at a subway station in Shanghai, China.
Yen Nee Lee | CNBC

Off-balance sheets activities have also slowed, with a recent Moody's report showing shadow banking "barely grew" from 64.4 trillion yuan in the first half of 2016 to 64.7 trillion yuan in the first six months of 2017. While some observers said credit had simply transferred to more regulated areas, others said moving away from the shadows is still a positive development.

The efforts to move away from shadow banking practices are set to continue. Beijing has proposed greater oversight on wealth management products, estimated to be worth some 29 trillion yuan ($4.39 trillion) outstanding at the end of 2016, with 80 percent off the books.

The proposals include prohibiting issuers from dipping into their own capital to compensate investors for losses — closing a loophole thought to have encouraged risky lending behavior and the growth of the shadow banking business.

The better economic backdrop has help companies to improve their cash flows and pay down some of their debt, experts said. The proportion of bad debt to total loans in Chinese commercial banks stayed steady at 1.74 percent at the end of September, unchanged from the second quarter, official data showed.

While some said China's official bad loans data may understate the actual situation, most experts whom CNBC spoke to agreed that asset quality is improving in Chinese banks.

And for the first time since the final quarter of 2011, China's debt-to-GDP ratio didn't increase and stayed unchanged at 255.9 percent in the second quarter this year, latest data by the Bank for International Settlements showed.

"Broadly, China is making progress in controlling its debt in various parts of the economy," said Christopher Lee, managing director in the corporate ratings group and chief ratings officer for Greater China at S&P Global Ratings.

"There is no one-size-fits-all way to deleverage and the government is utilizing a combination of incentives, deterrents and regulatory changes to facilitate an economy-wide deleveraging process," he added.