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China urgently needs to tackle its corporate-debt problem before it becomes a major drag on growth in the world’s No. 2 economy. Corporate debt has reached very high levels and continues to grow. In our recent paper, we recommend that the government act promptly to adopt a comprehensive program that would sacrifice some economic growth in the short term while rapidly returning the economy to a sustainable growth path.
Let’s first take a look at the dimensions of the problem. From 2009 to 2015, credit grew very rapidly by 20 percent on average per year, much more than growth in nominal gross domestic product. What’s more, the ratio of non-financial private credit to GDP rose from around 150 percent to more than 200 percent, or about 20-25 percentage points higher than the historical trend. Such a “credit gap” is comparable to those in countries that experienced painful deleveraging, such as Spain, Thailand, and Japan (see Chart 1).
This corporate credit boom reflected the government efforts to stimulate the economy in the wake of the global financial crisis, largely through lending for infrastructure and real estate. The outcome: overbuilding and a severe overhang of unsold properties, especially in lower-tier cities, along with excess capacity in related industries such as steel, cement and coal. The combination of heavy borrowing and falling profits led to excessive debt loads. The problem has been worst among state-owned enterprises that benefit from preferential access to financing and implicit government guarantees, which lower the cost of borrowing.
So what is the solution? First, the government should make a high-level decision to stop financing weak companies, strengthen corporate governance, mitigate social costs and accept likely slower growth in the near term. It needs buy-in at every level—state-owned enterprises, local governments, and financial supervisors. Here are the other steps China’s government can take:
To make the program work and limit the short-term economic pain, other supportive measures are needed:
Risks appear manageable if the problem is addressed promptly. Indeed, it is encouraging that the government has recognized the problem and is taking action to address it. The comprehensive strategy we have outlined would allow China to reduce leverage, limit vulnerabilities, and return to a strong and sustainable growth path over the medium term.
Read our recently published working paper for more information.