Why China Won’t Suffer a“Debt Crisis”

By+JOHN+ROSS

INACCURATE articles sometimes appear in the Western media claiming China faces a “severe debt crisis.” Factually these are easily refuted. Changyong Rhee， the IMFs Asia and Pacific Department director， recently pointed out that Chinas national and local government debt is only 53 percent of GDP， while the U.S. governments debt is roughly equivalent to GDP， and Japans government debt is 240 percent of GDP. Foreign debt is nine percent of Chinas GDP – insignificant bearing in mind that it owns the worlds largest foreign exchange reserves.

Factually， it is therefore unsurprising that Chinas predicted “Lehman” or “Minsky” moment， a financial collapse， invariably fails to occur. But there is another， even more fundamental， reason why Chinas economy does not suffer severe financial crises of the type that struck the Western economies in 2008 or wracked the Eurozone. As this illustrates how Chinas economic structure is superior to the Wests it is worth analyzing.

Starting with fundamentals， the way the argument is constructed wherein China faces a “serious debt crisis” violates the most elementary accounting rule – namely that of double entry book keeping， which was invented in Italy“merely” eight centuries ago！ It denotes that for every debit entry there has to be a credit one， and vice versa. Discussion of only one side of a balance sheet without the other is financial nonsense. Claims， such as in the Financial Times， that the big story of 2014 is “the black cloud of debt hanging over China” are financially meaningless given they do not discuss assets as set against debt.

To illustrate this elementary accounting principle take a simple example. A company borrows US $100 million at 5 percent interest， uses it to build houses， and sells them at 15 percent profit. To declare “there is a crisis –the company has a US $100 million debt” is evidently nonsense. The company has debts of US $100 million but assets of US $115 million. It can repay US $105 million and make US $10 million profit – there is hence no “debt crisis” whatever. That its assets are greater than its debt illustrates why it is financially illiterate to discuss only debt without assets. A “balance sheet” is so called because it has two sides， not one.

Apply this to China and the Wests financial systems. Evidently no financial problem exists in either if a borrower makes a profit on a loan – they repay it. A problem only exists if the borrower does not make sufficient money to repay the debt.

If the borrower is a small or medium one， again there is no difference between Western and Chinese financial systems. In both cases the borrower partially or fully defaults and， if necessary， goes bankrupt.

Specific criticisms can be made， which this author would tend to agree with， that in the Wests system companies are sometimes too easily allowed to resort to bankruptcy to escape debts. China， meanwhile， has propped up some companies that would have been better allowed to go bankrupt. But these are details that do not affect the essence of the matter. China is now taking a more robust line in forcing into default small and medium borrowers that cannot repay loans. Shanghai Chaori Solar Energy Science and Technology recently defaulted without bailout.

But， by definition， individual bankruptcies of small and medium companies do not affect the financial systems viability – they are a normal part of market functioning. The key difference between Chinese and Western financial systems comes from debts by large institutions– “system making” ones to use technical economic terms. Here Western and Chinese systems differ – and Chinas is superior.

First take Western government debt. As Western governments ideologically oppose state investment， Western state borrowing is overwhelmingly used not to finance investment but consumption， via social security payments， unemployment pay and etc. For example， in the U.S. at the depth of the post 2008 Great Recession， annual government borrowing was 13.6 percent of GDP but state investment was only 4.5 percent – borrowing overwhelmingly financed consumption. As Western government debt primarily finances consumption it therefore creates no lasting asset. That is why in the West it is not wholly misleading to look at state borrowing purely from the debt point of view – even if it is wrong conceptually.

Chinas is different. The bulk of borrowing， particu-larly by local governments， is for investment， primarily in infrastructure. Borrowing therefore creates lasting assets– roads， subways and housing. Assets in turn create revenue streams directly， indirectly， or both. Direct revenues are fares， rents， and tolls. Indirect revenues are generated because infrastructure investment promotes economic growth， yields taxes， and has well-known effects in raising land values – land sales being one of Chinese local governments biggest sources of income.

As Chinas government debt is used for investment， not consumption， analysis that does not financially offset debt with assets created by them is not merely formally wrong but constitutes a serious actual mistake. Similarly， company borrowing is primarily used for investment， i.e. asset creation.

This leads to a final difference between China and the West. In both Western and Chinese financial systems， if the value of an asset created by borrowing equals at least the value of the debt， there is evidently no problem. The difference between the two comes with bad investments– where the value of the asset created does not equal the borrowing.

A major financial crisis occurs when there are largescale bad investments by “system making” institutions， those that are “too big to fail.” This need not be a single bad investment but can be large numbers of small bad investments， as with the U.S. sub-prime mortgage crisis. In these cases， in both the West and China， only the state has the resources to solve the problem. But the way the state intervenes is entirely different in China and in the West.

In the West the financial system is fragmented – individual institutions are financially separate. As there is no unified financial system， the necessary transfer of resources from the state， to prevent collapse of “system making” institutions， is therefore external and chaotic. For example， following Lehmans collapse， essentially every private Western bank had to be salvaged by government subsidies and direct nationalization. The same occurred with GM and Chrysler. In Greece the EU and IMF ordered partial bond defaults and bailout packages. The transfer of resources from the state， and in some cases private bond holders， was via the chaotic “crisis” way –the “Lehman moment.”

Basic laws of economics cannot be avoided， so if in China a substantial number of bad loans occur， as with banks in the 1990s， the state also has to transfer resources. But in China the core of the financial system is not fragmented， but a single integrated whole comprising central government， local governments， state banks， and large state-owned companies. Resources are therefore not transferred by chaotic crisis as in the West， but within this integrated financial system. Chinas financial system could be conceptualized by the analogy of a single person transferring money from one bank account to another – for example from the central government to bail out local governments. Or， to put it more popularly， it is as though money is transferred from one pocket to another.

A transfer of resources from the state therefore takes place in China， as in the West， but in an orderly and not a chaotic fashion. That is why China never has a “Lehman moment” or a “Minsky moment，” a large-scale financial crisis – the superiority of Chinas financial system to the West precludes it happening.

To avoid misunderstandings， this does not mean that large-scale bad investments made in China do not create problems. If， for example， a bad railway investment is made which fails to generate adequate users， the resources transferred within the system to bail it out preclude their availability to build a railway which is actually required. The problem therefore does appear in the form of systemic financial crisis， not for reasons outlined， but in the form of a decline in the economys overall investment efficiency， as resources are sucked into inefficient ventures at the expense of efficient ones.

The data on this latter process is clear. Every major economy suffered a decline in investment efficiency as a result of the international financial crisis. Taking the five years after the start of the financial crisis， the percentage of GDP that had to be invested in China for its economy to grow by one percent rose from 3.4 percent to 4.9 percent – Chinas investment efficiency fell under the impact of the global financial crisis. But in the U.S. the percentage of GDP that had to be invested for the economy to grow by one percent rose from 8.1 percent to 33.1 percent！ In other words， China came through the negative consequences of the international financial crisis much more successfully than the U.S.

Because they ignore elementary accounting rules， those claiming that China will suffer a severe “debt crisis” are writing financial fairy stories – they never actually occur.