The rapid increase in leverage in the emerging markets of Asia, particularly China, has become a concern for many investors globally. What is the source of
the debt buildup? How will it play out? Japan’s experience in dealing with high levels of debt can offer insight.
Since the global financial crisis, most countries around the world have increased their debt levels, including those that were already highly indebted,
such as Japan.
Emerging Asian countries also increased leverage, and the growth of debt has been notably high. Most Asian countries are already approaching a number of
developed countries in debt-to-GDP terms (see Figure 1).
In the developed markets, the public sector has been the main contributor to debt growth since the financial crisis, while private debt, especially in the
U.S., has declined. The story in emerging Asia is quite different.
Compared to the rest of world, emerging Asia stands out in terms of leverage growth since 2007. It is not just the fast pace in credit growth that is a
concern; credit growth has been faster than GDP growth. Thus, emerging Asian economies need more credit to generate the same amount of economic growth as
in the past.
Against this backdrop, external sovereign debt is not a big risk, in our view. In 1997‒1998, external debt was a contributing factor to the Asian financial
crisis. Today, Asia as a whole is less vulnerable externally. China’s external debt-to-GDP ratio, for example, is one of the lowest among emerging
countries. PIMCO, in fact,
foresees improving fundamentals in many emerging markets
(see “A Constructive Case for Emerging Markets”).
Malaysia is one of the few exceptions in Asia; its external debt metrics have deteriorated since 2007. Indonesia is the most stretched in terms of external
debt to foreign exchange reserves and foreign currency debt exposure relative to GDP. But even these countries are in a better position compared with other
emerging market countries, such as Argentina, Turkey and South Africa.
However, banking liquidity, viewed as loan-to-deposit ratios, has worsened in some countries in Asia since 2007. As a result, even if external imbalances
may be improving, internal imbalances are becoming more visible.
As for household indebtedness, emerging Asia is diverse, suggesting different degrees of upside potential for household consumption and policy flexibility.
Malaysia and Thailand are of special concern. Not only is household debt to GDP high compared with other countries, but it is also high relative to their
stage of economic development (measured as GDP per capita). On the other hand, households in other countries in the region – including China and India –
are in better shape and have the potential to lever up and consume more.
With sovereign debt relatively benign and consumer debt a mixed picture, where then is the problem in emerging Asia? The corporate sector. Corporate
leverage accounts for around half of the region’s debt to GDP. Companies in China are the most extended both in absolute terms and in debt relative to GDP,
which well exceeds 100%. India’s listed corporates are also highly levered with debt-to-equity ratios as high as their Chinese counterparts (see Figure 2).
China: Problems and policy options
Given the size of its economy – and the high stock of debt for a country at its stage
of development – China’s leverage will be a global issue in the future, not just a China issue.
Total debt to GDP in China was around 250% at the end of 2015, the highest among emerging economies (see Figure 3), and we think China’s debt ratio is on
track to reach 280%‒300% of GDP by 2020. This assumes that reforms in the state-owned enterprise (SOE) sector will make only partial progress and that the
gap between credit and GDP growth does not narrow substantially. Over the medium term, we expect more debt creation in China: Leverage is unavoidable for
China to achieve its growth targets.
Corporate debt – at more than 120% of GDP – remains the key cause for concern in China (see Figure 4). Its corporate debt ratio increased by 70 percentage
points from 2007 to 2015, as credit growth consistently exceeded GDP growth by a wide margin. Meanwhile, declining corporate profitability has generally
eroded companies’ ability to service their debt. Profitability has deteriorated more sharply for SOEs than in the private sector.
In PIMCO’s view, China’s nonperforming loans (NPLs) will trend higher in the next three to five years from a reported NPL ratio of 1.4% at the end of 2015.
If China can successfully manage through the deleveraging process in its corporate sector, then the NPL ratio in the banking system should peak at around
6%; otherwise, the NPL ratio will likely continue to rise.
What will China do in dealing with its mounting leverage? Policymakers appear to have two options.
China moves more aggressively to remove the moral hazard in its financial system. That would be the prudent thing to do but would release pent-up perils;
defaults would climb, and banks would rack up losses.
China postpones reform and instead tries to patch the current system (“kick the can down the road”). That would be safer in the short term, but the
inexorable accumulation of debt would slow the economy over the secular horizon and raise the odds of a hard landing in the future.
In our base case, China will take Option 2 and move only temporarily to Option 1
in good, calm times, resulting in a slow-moving process that shifts between the two approaches. To be sure, China’s central government has the capacity to
handle a financial crisis if one materializes (though we foresee no “Minsky moment” over the next few years). However, China’s journey could become bumpier
than our base case due to 1) China’s political dynamics, 2) geopolitical events or 3) low or uneven economic growth in the rest of the world that derails
China’s deleveraging process.
China faces similar challenges today as Japan did in the past:
The need to rebalance from investment to consumption
(which Japan experienced in the 1970s)
- Credit- and asset-bubble risk (Japan in the 1980s)
- A rapidly aging population (Japan since the mid-1990s)
In dealing with their debt problems, China and Japan share an important advantage – they are external creditors. They also have important differences,
however, which should make China’s deleveraging process (when it finally happens) more complicated for the rest of the world:
- China’s global spillover effect should be larger than Japan’s due to China’s size, its commodity and emerging market linkages and its still-evolving
exchange rate regime.
- China has an uncertain and complex political trajectory.
- The rest of the world, particularly developed countries, still faces the challenge of stimulating growth following the global financial crisis.
- China today is facing all three of these challenges simultaneously, while Japan had the opportunity to deal with each one of them sequentially.
Japan’s experience with leverage
Japan is a clear example of Option 2, the slow resolution path, which we think China will primarily take as well.
NPLs in Japan were understated at the beginning and dramatically increased only after the banking crisis of 1998. Banks had kept credit costs substantially
low, and zombie companies were kept alive on the back of them, reducing the number of defaults but prolonging the pervasive misallocation of capital.
Corporate sector deleveraging in Japan did not take place until the government stepped in to borrow in the late 1990s (see Figure 5). It could have
happened much earlier and more quickly if monetary policy easing had been swifter and the Bank of Japan had allowed the Japanese yen to depreciate by a
While the slow resolution of the corporate debt problem helped limit any financial contagion risk within the country, Japan has paid the high cost of a
prolonged deflationary environment since then.
Macro and market implications
What are the general consequences of debt buildups to the economy and financial markets?
A 2015 study by Goldman Sachs showed that in the wake of debt buildups, a country’s real economic growth and inflation have declined relative to prior
trend levels. It also found that the size of the debt buildup determines the degree of economic slowdown that ensues. Not surprisingly, monetary policy
typically is easier after debt buildups on the back of slower growth and lower inflation. The amount of monetary policy accommodation varies, perhaps
depending on starting conditions, including the initial level of the policy rate.
Foreign exchange is key. Smaller and open economies seem to succeed in depreciating their exchange rates, which generally helps with the deleveraging
process by regaining export competitiveness. Larger economies, however, see their exchange rates remain stable or even appreciate, while depreciation is
preferred for deleveraging. Part of the reason is that the rest of world may not be in a position to tolerate appreciation of their own currencies. This
may have an interesting implication for China’s cyclical and long-term outlooks.
To conclude, rising leverage should be an important consideration for investors in emerging Asia, but we do not expect a severe or sudden negative effect.
We do anticipate long-term effects: Dealing with higher corporate leverage, particularly in China, will likely mean slower growth, further pressure for
currency adjustments, lower inflation and additional central bank accommodation in the years to come.
SPEED READ: ASIA’S UNIQUE DEBT-GROWTH STORY
- External imbalances are improving, but internal imbalances are deteriorating.
- Households in China and India have the potential to lever up and consume more.
- The corporate sector is the single-biggest regional concern.
- China’s leverage is a global problem, not just a China problem.
- China faces similar challenges as Japan did in the past.
- Dealing with high leverage will likely mean slower growth, currency adjustments and additional policy accommodation.