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China's economic balancing act

The model for credit-financed growth is reaching its limits. China's government needs to focus on structural reforms.

The Chinese government responded with incomprehension to Moody's downgrade of China's credit rating from Aa3 to A1 – the first downgrade since 1989. Rising debt was the main factor leading to the downgrade announced in May. Measured in terms of gross domestic product (GDP), China's corporate, consumer and state debt levels combined have risen from 141.3% at the end of 2008 to 257.1% at the end of 2016, whereby the majority of this increase is attributable to state-owned enterprises and provincial governments. # The sharp rise in China's debt versus economic output is what prompted Moody's to issue the downgrade. #

Yet, in the same announcement, the rating agency went on to explain that the deterioration in credit quality was only gradual and could still be contained by deepening reforms. China's government was visibly disgruntled by the downgrade # and sees no danger of a debt crisis, pointing to the measures already implemented to stabilize the financial sector. Provinces and state-owned enterprises have been instructed to analyze their debt situation and take measures to consolidate it.

Continued debt increase

In previous years, China had put a brake on spending and credit growth, which simultaneously slowed down both investment and economic expansion. It's important to point out that despite monetary tightening, the economy continued to grow. In our view, this should continue. Nevertheless, debt could continue to grow faster than economic output, which would push the debt ratio of China's economic players higher and most certainly cause unease.

To avoid this, the government's aim under Prime Minister Li Keqiang is to steer and regulate the financial sector in a manner that instills confidence. Numerous provincial infrastructure projects and a relaxed monetary policy led to a boom in construction and soaring real-estate prices. The government and the central bank have now begun to curb construction and price increases by tightening lending standards and raising interest rates.

These measures have put a significant damper on increases in metropolitan real-estate prices for the past two quarters. The state has also taken a closer look at the shadow banking system in the past year. The government is working to curtail the uncontrolled lending to avoid credit defaults, which lead to uncertainty and can be a burden on the real economy. At the same time, the government is well aware that measures to stabilize the monetary sector are not enough to spur China's economic reforms or growth.

Stabilization coupled with reforms

Along with fighting corruption and implementing structural reforms, the government is also aiming at strengthening the country's real economy. Since 2014, there have been 1.16 million corruption investigations, showing the first signs of success in containing corruption in 2016. # The focus of structural reforms is on less profitable state-owned enterprises who are being encouraged to pull back on their investment plans. The government's intention is to reduce excess capacity in sectors such as steel, aluminum, cement, paper and oil refining and free up investments that can be used by privately-owned, high-growth companies. In fact, while there has been a significant decline in investment growth at state-owned enterprises over the past two quarters, investment growth at private companies – which account for a little more than half of the total investment – has been on the rise.


In conclusion, China's leaders are looking to limit the pace of rising debt, while at the same time trying to limit the negative effect on investment. The government also intends to regulate the financial sector more tightly without harming investment in innovative sectors. "This will be something of a balancing act, where the focus is centered on restructuring the economy," explains Xueming Song, Chief Economist Asia at Deutsche Asset Management. It’s essential that the economy continues to grow while restraining the rise in debt at the same time. Necessary structural reforms, such as reducing excess capacity, act as a brake on the economy. Credit-financed expenditures stimulate the economy but at the same time increase debt.

The answer for China's government is to use loans for worthwhile investments that will in turn lead to added growth. A look at the investment-rate-to-growth ratio in various emerging economies shows that China ranks below average in terms of its use of investment funds. India scores much higher in this respect. This would indicate that one of the goals of the Chinese government should be to significantly raise its investment efficiency: faster growth through smarter investment. This should also help reduce the rise in the debt ratio for the overall economy.

Rising debt levels

Debt growth has been trending downwards in China, but the problem is that it continues to outpace nominal GDP growth.

Sources: International Monetary Fund, Bank for International Settlements; as of 6/12/17

Investment efficiency in the emerging economies

China's investment ratio is 45% and expected growth is 6.25%. China's aim is to raise its below-average investment efficiency.

Source: International Monetary Fund; as of 6/12/17


Bank for International Settlements: Total Credit to the non-financial sector; as of 6/12/17


Moody's Investors Service: Rating Action: Moody's downgrades China's rating to A1 from Aa3 and changes outlook to stable from negative; as of 5/24/17


Bloomberg: China Hit by First Moody's Downgrade Since 1989 on Debt Risk; as of 5/24/17


The Japan Times: China anti-corruption dive has punished 1.2 million; as of 1/10/17

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