• Since the global financial crisis, China’s economy has experienced an unprecedented increase in debt levels.
• The risks of this debt can be fully understood only in the context of the interconnected assets and liabilities between households, corporations, financial institutions, and the government.
• Four factors are most relevant for analyzing the strength of China’s balance sheets: solvency, liquidity, interdependency, and composition.

Over the past several years, financial risks emanating from China have become an increasing source of concern. A financial crisis in China would have far-reaching consequences beyond its borders and could potentially jeopardize global financial markets.

Prevailing Winds is a China-focused blog written by Nicholas Borst, Director of China Research at Seafarer. The blog tracks the economic and financial developments shaping the world’s largest emerging market.

At the core of the threats to China’s economy is the rapid growth of debt. Chinese authorities have sought to contain the growth of debt and reduce its riskiness, but financial distress continues to emerge in many parts of the Chinese economy. A long list of Chinese conglomerates – including Evergrande, Huarong, HNA, and China Fortune Land – have captured headlines recently as they have fallen into bankruptcy.

While there has been no shortage of inquiries into China’s financial risks, most analysis focuses on debt in isolation or relative to income. This approach is incomplete. The true riskiness of China’s debt is better evaluated in the context of its national balance sheet. This Prevailing Winds post provides a framework for doing so.

A Deluge of Debt

Since the global financial crisis, China’s economy has been threatened by the specter of growing debt. Between 2008 and 2020, total credit in China increased by over 39 trillion USD.¹ This surge was nearly 40% greater than the increase in the United States, which experienced its own rise in borrowing during this period. Total credit in China is significantly greater than all other emerging markets combined and is approaching the level of the U.S., as shown in Figure 1.²

Sources: Bank for International Settlements, Seafarer.

As a share of gross domestic product (GDP), China’s total debt level is similar to the United States’ and significantly greater than the emerging market average, as shown in Figure 2.

Sources: Bank for International Settlements, Seafarer.

Debt increases in the U.S. have been driven by government borrowing. In contrast, corporations and households have been responsible for most of the increase in China. In fact, China’s corporate debt by itself is equivalent to the combined value of all emerging market debt (corporate, government, household). Figure 3 shows the composition of China’s debt.

Sources: Bank for International Settlements, Seafarer.

A Balance Sheet Approach

China’s rapid accumulation of debt after the global financial crisis is unprecedented for a major economy. The explosion in debt has increased risks across the financial system. Many industries – including China’s over-leveraged real estate market—are currently facing financial stress.

Debt is only part of the picture, however. It can be fully understood only in the context of China’s national balance sheet, which can be divided into four interconnected balance sheets that represent the primary economic sectors: households, corporations, financial institutions, and the government. These four balance sheets add up to the national total. Their strengths and weaknesses are interdependent.

Figure 4 shows China’s total national balance sheet and four subnational balance sheets. The data, produced by the Center for National Balance Sheet at the Chinese Academy of Social Sciences, is remarkable for its detail and transparency. Each of the balance sheets includes tens of trillions of dollars’ worth of assets and liabilities. The balance sheets are divided between non-financial assets (fixed assets and inventories) and financial assets (loans, deposits, equity, and other financial assets). Only two of the subnational balance sheets, households and the government, have a positive net worth (assets greater than liabilities). The other two have zero net assets, because the equity of corporations and the financial sector is ultimately owned by either individuals or the government.

There are many different ways to analyze the strength of a balance sheet. This analysis looks at the four factors that are most relevant for analyzing aggregated and interconnected balance sheets: solvency, liquidity, interdependency, and composition.

Solvency

Solvency refers to the ability of a borrower to meet its long-term debt obligations. A borrower with positive net worth is generally considered solvent. Its solvency depends on the assets being priced correctly and valuations remaining stable, however. Staying solvent requires that a borrower be able to service its debts over time, through income, the sale of assets, or borrowing.

In the context of a national balance sheet, the financial sector provides credit to the household, corporate, and government sectors. These balance sheets are perpetual, meaning that they persist over the longest time horizons: Debt owed by individual households and corporations matures, but collectively the debt pool is continuously rolled over into the future.

Ratios like debt-to-assets or debt-to-equity can be useful in evaluating the solvency of subnational balance sheets. They provide a rough sense of whether debt is manageable.

The debt-to-equity ratio of households and the government increased considerably between 2014 and 2019, but the ratios are still moderate, as shown in Figure 5. For corporations, the increase in debt was balanced against increasing equity valuations. The corporate debt-to-equity ratio therefore showed no clear trend over the past two decades.

Sources: Center for National Balance Sheet, Seafarer.

Asset price bubbles can skew debt-to-equity ratios. Soaring asset prices boost equity values and lower debt-to-equity ratios. If valuations are stretched or driven by speculation, they can quickly collapse, exposing weakness in a seemingly healthy balance sheet. For example, the low leverage of Chinese households’ balance sheets is a product of significant home equity and ownership of corporate assets. If the value of either category of assets declines significantly, China’s household balance sheet might look far riskier.

Liquidity

Liquidity refers to the ability of a borrower to meet its short-term debt obligations. A borrower may have a high net worth, but if its assets are illiquid and it cannot meet its current obligations, it will be forced into bankruptcy. If assets are illiquid, have high transactions costs, or cannot easily be sold off in chunks, an equity-packed balance sheet may not provide a good buffer during periods of financial distress. To assess liquidity, it is important to look at current income relative to current liabilities and the ability to borrow and sell assets to satisfy short-term debts.

China’s increase in total leverage has led to a significant debt-servicing burden across the economy.³ Relative to annual income, debt-servicing costs to households and corporations increased significantly after 2009, as shown in Figure 6. Historically, increasing debt service ratios have been an early indicator of financial distress.⁴

Sources: Bank for International Settlements, Seafarer.

Interdependency

Interdependency refers to the interactions between different balance sheets and the ways in which their strengths and weaknesses are linked. Assets held by the financial sector are liabilities for the household, corporate, and government sectors. The equity of corporations ultimately resides as an asset held by either the household or government sector.

Interdependency means that an economy may be only as strong as its weakest balance sheet. For example, the net worth of the household and government sectors could be reduced by a significant deterioration of the corporate or financial sector balance sheet. Understanding these interlinkages is key to evaluating how a balance sheet may perform under stress.

Composition

Composition refers to the distribution of assets and liabilities on a balance sheet. Each of the four subnational balance sheets is the aggregation of many smaller balance sheets. The household balance sheet, for example, is the sum of the balance sheets of hundreds of millions of households. The corporate and financial sector balance sheets are the sums of the thousands of businesses and financial institutions operating in China. The government balance sheet is the sum of the balance sheets of the central government and many provincial and subprovincial governments.

A balance sheet may look strong in the aggregate, but it may hide many weak individual balance sheets. The household sector as a whole may have a relatively low debt-to-equity level, but millions of households may be heavily indebted and at risk of default. The corporate balance sheet appears robust, even though some companies and industries have high debt risks. The government balance sheet looks strong because of the low indebtedness of the central government, but many local governments are highly indebted and facing financial stress.

Diversification of a balance sheet can reduce risks. If risks are diversified across many smaller balance sheets, the combined balance sheet will be less exposed to any single risk and therefore more resilient.

Diving Deeper

A related Prevailing Winds post, How Strong is China’s Household Balance Sheet?, uses the framework outlined here to better understand the strengths and weaknesses of China’s household balance sheet. This exercise should help investors understand whether China’s rapid increase in debt may be a prelude to a financial crisis.

As of December 31, 2021, the Seafarer Funds did not own shares in the securities referenced in this commentary.

The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.

1. “Credit to the Non-financial Sector,” Bank for International Settlements, 1 November 2021.
2. The emerging markets included in this dataset are Argentina, Brazil, Chile, Colombia, the Czech Republic, Hong Kong SAR, Hungary, India, Indonesia, Israel, South Korea, Malaysia, Mexico, Poland, Russia, Saudi Arabia, Singapore, South Africa, Thailand, and Turkey.
3. “BIS Database for Debt Service Ratios for the Private Non-financial Sector,” Bank for International Settlements, 23 May 2017.
4. Mathias Drehmann and Mikael Juselius, “Do Debt Service Costs Affect Macroeconomic and Financial Stability?,” Bank of International Settlements, September 2012.