A. Introduction

1. Strong growth after the global financial crisis was driven by rapid credit growth. Nominal credit to the nonfinancial sector more than doubled in the last five years, and the total domestic nonfinancial credit-to-GDP ratio increased by 60 ppt to about 230 percent in 2016 (Box 1). As a result, the credit gap—deviation of the credit-to-GDP ratio from its historical trend—is currently about 25 percent of GDP, well above the 10 percent BIS threshold for the maximum counter-cyclical buffer.

B. Why Worry About China’s Credit Boom?

2. Credit efficiency has been deteriorating, pointing to increasing resource misallocation. Credit to certain sectors (industrial), firms (SOEs), and regions (Northeast) is significantly higher than their value added, suggesting that they use credit relatively inefficiently. In 2007–08, new credit of about RMB 6½ trillion was needed to raise nominal GDP by about RMB 5 trillion per year; in 2015–16, it took RMB 20 trillion in new credit.

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Credit Intensity

Citation: IMF Staff Country Reports 2017, 248; 10.5089/9781484314722.002.A002

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3. Sustainable growth—growth that can been achieved without excessive credit expansion—was likely much lower than actual growth over the last five years. For illustrative purposes, we estimate growth under a scenario in which the nonfinancial private sector credit-to-GDP ratio had only increased by 10 ppt, leading to no private sector credit gap in 2016. We use two approaches. The first approach calculates credit and GDP growth paths if credit efficiency had worsened less, in line with slower credit growth. The results indicate that average real GDP growth for 2012–16 would have been 5.3 percent rather than the actual average of 7.3 percent. The second approach (Chen and Ratnovksi, 2017) estimates growth using provincial panel data during 2003–15, assuming a lag in the effect of credit growth on output growth. It finds that 2012–16 average real GDP growth would have been 5.9 percent. However, the growth-subtracting effect of credit restraint could have been partly offset by pro-rebalancing, on-budget fiscal stimulus as well as by the productivity gains from more decisive structural reforms.

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Sustainable GDP Growth

(percent)

Citation: IMF Staff Country Reports 2017, 248; 10.5089/9781484314722.002.A002

1/ Kang, Chen, and Law (2017)2/ Chen and Ratnovksi (2017)

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4. International experience suggests that China’s current credit trajectory is dangerous with increasing risks of a disruptive adjustment and/or a marked growth slowdown. We identify 43 cases of credit booms in which the credit-to-GDP ratio increased by more than 30 percentage points over a 5-year period. Among these, only 5 cases ended without a major growth slowdown or a financial crisis immediately afterwards. However, considering country-specific factors, these 5 country provide little comfort.² In addition, all credit booms that began when the ratios were above 100 percent—as in China’s case—ended badly.

5. Complex and primarily short-term funding structures underpinning rapid credit growth are a key vulnerability. Banks’ rapid asset expansion has relied on increasingly complex funding structures, extending beyond deposit funding to interbank markets and wealth management products, and via complex and interlinked networks of entities. Asset managers often finance illiquid long-term investments by rolling over short-term funding or pooling investment funds. Complex funding structures and sizable, opaque off-balance sheet investments suggest that a deleveraging process in the financial sector could be bumpy.

C. Can China-Specific Buffers Prevent Financial Stress?

6. There are several China-specific factors that could be mitigating factors over the near term. A current account surplus and small external debt reduces the possibility for a typical external funding crisis as in many other EMs. A low bank loan-to-deposit ratio could help prevent a domestic funding crisis as well. Despite the rapid increase in gross debt, corporate balance sheets have also benefitted from asset values that have increased more than liabilities. Policy buffers can also mitigate the impact of potential shocks: the government can use its fiscal resources to backstop the system, the PBC can always provide liquidity, and capital controls can contain capital flight

7. However, these mitigating factors/buffers do not eliminate the eventual crisis risk and, if the risk is left unaddressed, would just make the boom larger and longer.

• Strong external position Persistent current account surpluses and low external debt could help avoid a typical external funding crisis as in many other EMs.

  • However, several countries experienced credit booms that ended badly despite running current account surpluses and/or small external debt, as funding crisis could still occur without foreign funding exposure. If financial institutions are expanding their balance sheets by relying on short-term funding amid ample liquidity, a funding squeeze could trigger a downturn/crisis. The U.S. savings and loan crisis in the 1980s, Japan’s banking crisis in 1997, and the U.S. and U.K. financial crises in 2008 are such examples.

• High domestic savings and stable domestic deposit base. A low bank loan-to-deposit ratio (narrowly-defined, 72 percent in 2016) could help prevent a domestic funding crisis. Even the total nonfinancial domestic credit-to-GDP ratio at 118 percent is well below other countries that experienced funding crises (e.g., 400+ percent in Korea (1998), 350+ percent in the US (2008), 250 percent in Japan (mid-1990s)).

  • However, loan-to-deposit ratios do not capture total assets and liabilities. Many countries experienced crises despite stable deposit funding; these cases are usually associated with balance sheet expansion through non-loans and non-deposit funding. Many of these assets may be weakly regulated (and collateralized), while funding sources tend to include interbank exposure, which potentially increase systemic risk. In China, the ratio of non-loan assets to total assets is about 50 percent in 2016, higher than the median in the cross-country sample.

• Strong asset side of balance sheets. Corporate balance sheets have benefitted from rising asset values, which have increased more than liabilities. So, leverage as measured by the debt-to-asset ratio has been falling.

  • However, asset valuations could fall sharply were the boom to end. Corporates’ liabilities are mostly financial liabilities, while a significant portion of assets are nonfinancial fixed assets (e.g. land), which may not be easily liquidated and are subject to sharp valuation changes. In addition, more vulnerable firms—for example, those with lower debt servicing capacity—tend to hold fewer liquid assets, implying that such firms would have lower buffers during times of stress.

• Ample fiscal space in a state-controlled economy. The government has fiscal space with official general government debt of less than 40 percent of GDP as of 2016. The government could use its resources to backstop the system.

  • However, actual fiscal space is limited and is eroding with “augmented” debt projected to rise to more than 90 percent of GDP over the medium term, with debt on an unsustainable path. The economy-wide cost of bailouts is likely to be larger than just the direct costs for the financial system due to indirect costs (slower GDP growth, lower tax revenue, higher government spending, higher interest payments, and contingent liabilities). The process of bailing out may not be smooth, and even if the government successfully uses fiscal resources, it could deepen moral hazard and increase the potential cost of future bail outs.³

• Liquidity provision and capital controls. The PBOC can always provide liquidity against funding stress and capital controls are still very effective.

  • However, even quick action by central banks may not be sufficient (e.g. the U.S. in the global financial crisis) given the size, complexity and interconnectedness of the system. If funding stress were to occur (such as in small banks or non-banks), it is uncertain if such stress could be contained by the authorities given the complexity of the system. Liquidity provision could also lead to capital outflows and FX pressure, as well as exacerbating moral hazard. Capital controls could be tightened substantially, but this could spur a growth slowdown and possibly provoke further capital outflows. Further, such controls tend to lose effectiveness over time.

• Strong growth and financial deepening. Rapid credit growth is natural consequence of strong underlying growth and could reflect financial deepening.

  • However, faster growth is unlikely to be the answer as the efficiency of investment/credit is falling sharply and financial performance (profitability, leverage, debt servicing capacity) of corporates—particularly SOEs—is deteriorating, affecting asset quality of banks. China’s rapid financial deepening has exceeded the turning point that maximizes the positive effect on growth (IMF SDN/15/08); further financial deepening could even drag growth lower.

(In percent of GDP)			2008	2009	2010	2011	2012	2013	2014	2015	2016
Total deposit			139	163	166	165	170	176	182	191	200
Total credit to nonfinancial sectors			131	160	170	168	179	190	201	214	234
	Augmented public sector (GG + LGFVs + Gov funds)		38	43	42	43	44	48	52	57	62
		of which General Government a la IMF def.	27	34	34	34	34	37	40	43	44
	Private sector		93	117	127	125	135	142	148	158	172
		SOEs	40	46	54	53	57	60	61	66	74
		Non-SOE corporates	35	46	46	44	48	49	52	53	54
		Households	18	24	27	28	30	33	35	38	44
(In percent of total deposit)			2008	2009	2010	2011	2012	2013	2014	2015	2016
Total deposit			100	100	100	100	100	100	100	100	100
Total credit to nonfinancial sectors			95	98	102	102	105	108	111	112	118
	Augmented public sector (GG + LGFVs + Gov funds)		28	26	25	26	26	27	29	30	31
		of which General Government a la IMF def.	19	21	20	20	20	21	22	22	22
	Private sector		67	72	77	76	79	81	82	82	86
		SOEs	29	29	32	32	33	34	34	35	37
		Non-SOE corporates	25	29	28	27	28	28	29	28	27
		Households	13	15	16	17	17	19	20	20	22

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(In percent of GDP)			2008	2009	2010	2011	2012	2013	2014	2015	2016
Total deposit			139	163	166	165	170	176	182	191	200
Total credit to nonfinancial sectors			131	160	170	168	179	190	201	214	234
	Augmented public sector (GG + LGFVs + Gov funds)		38	43	42	43	44	48	52	57	62
		of which General Government a la IMF def.	27	34	34	34	34	37	40	43	44
	Private sector		93	117	127	125	135	142	148	158	172
		SOEs	40	46	54	53	57	60	61	66	74
		Non-SOE corporates	35	46	46	44	48	49	52	53	54
		Households	18	24	27	28	30	33	35	38	44
(In percent of total deposit)			2008	2009	2010	2011	2012	2013	2014	2015	2016
Total deposit			100	100	100	100	100	100	100	100	100
Total credit to nonfinancial sectors			95	98	102	102	105	108	111	112	118
	Augmented public sector (GG + LGFVs + Gov funds)		28	26	25	26	26	27	29	30	31
		of which General Government a la IMF def.	19	21	20	20	20	21	22	22	22
	Private sector		67	72	77	76	79	81	82	82	86
		SOEs	29	29	32	32	33	34	34	35	37
		Non-SOE corporates	25	29	28	27	28	28	29	28	27
		Households	13	15	16	17	17	19	20	20	22

8. These factors buy time to address risks from the unsustainable credit growth and allow China to delever gradually. We consider an illustrative proactive scenario under which faster progress on enacting structural reform (especially SOE reform) and improving overall efficiency in resource allocation would allow credit growth to slow gradually, while supporting medium-term growth prospects. Near-term growth could dip reflecting the faster adjustment, but medium-term growth would rise driven by higher TFP growth (Lam and others, 2017). Improved credit efficiency would help raise GDP growth even with slower credit growth over the medium term (private credit growth of about 8½ percent), which would stabilize the ratio of total domestic nonfinancial sector credit-to-GDP at about 270 percent in 2022.

9. Decisive policy action is thus needed to deflate the credit boom smoothly. A precondition is to deemphasize high and hard GDP targets and the attendant excessive credit necessary to achieve these targets. To support growth while credit expansion slows, a comprehensive strategy is needed to increase credit efficiency by reducing demand for least efficient/productive uses. Financial reforms are also necessary to bolster the regulatory and supervisory framework, including closing loopholes for regulatory arbitrage, reining in leverage and increasing transparency of nonbank financial institutions and wealth management products (Box 2).