Many pundits warn China’s debt woes doom it’s post-COVID recovery--and that of the world. They point to high-profile corporate defaults and downgrades cascading into a debt tsunami destined to reverberate globally—especially with China reducing stimulus. But that isn’t just wrong, it’s backwards. This very-manageable default increase demonstrates China’s recent commitment to liberalizing financial markets. It also signals a return to pre-pandemic normalcy awaiting the West—both broadly bullish worldwide.
Given Beijing’s recent Hong Kong crackdowns and extant Taiwan tensions, notions of China’s “liberalization” may seem deluded. Indeed, President Xi Jinping’s political moves spark strong emotions among investors. But these “foreign” policy issues are largely removed from financial markets—my limited area of expertise. Markets’ greater concern is Xi’s economic agenda. Here China is opening to free market forces more than ever.
Part of that: Refusing, unlike before, to bail out debt defaulters. Even big, state-owned firms the government long backstopped now are increasingly subject to market forces.
Pundits have seen this backwards from the get-go. They fretted rising Chinese defaults in late 2019, viewing China’s economy as teetering. Then pandemic emergency measures like increased lending, interest rate cuts and greater flexibility on existing loans gave debt-laden firms a brief reprieve. Those measures helped defaults drop 20% in 2020’s first three quarters.
Now, with rolling back pandemic relief efforts, new, high-profile defaults—and the downgrade of China’s largest distressed-asset manager— again stoke fear.
This doubling down makes debt doomers doubly wrong. Tighter credit and renewed defaults aren’t new. Nor are they negative. They simply signal China’s strong economic rebound letting it forego emergency measures and return to its economy’s pre-pandemic path. That is a rare and bullish signal globally. American and European policymakers aren’t even close to considering reining in existing “stimulus.” Heck, they debate adding more!
That will change. As I told you in November, being at COVID’s epicenter made China a leading indicator throughout this crisis. Its current path shows the brighter future ahead for America and the world. That future hopefully brings China ever more market-oriented liberalization--allowing increasingly unfettered defaults.
And all that pundit ballyhooed tightening? So far, it has been mild. Beijing’s official 2021 fiscal deficit target is 3.2% of GDP—down from 3.6% in 2020 but still above 2019’s 2.8%. Economists expect quotas for local special government bonds—off-budget funding sources—to fall from 2020’s 3.75 trillion yuan to 3.5 trillion yuan this year. The changes are relatively insignificant. Q1’s huge 18% y/y GDP surge was inflated due to Q1 2020’s low, lockdown base. Reality isn’t that big. But recent data show both manufacturing and services keep growing. China’s economy is just fine, thank you.
For example, China’s overall debt load isn’t nearly as daunting as some suggest. Data on Chinese firms’ debt-service ratio—the chunk of income going toward interest and principal payments—is sparse. That’s not optimal. But the Bank for International Settlements’ total private-sector debt-service ratio is a pretty good proxy. It includes loans and bonds, but also household debt—blurring the picture somewhat. Overall, the data aren’t troubling. In December 2019, the debt-service ratio was at 19.7%. Now it’s up slightly—to 21.0%. That tops America’s 14.3%, but is below developed nations investors don’t much fret like Canada, Denmark, Norway, France and Sweden.
Importantly, defaults are part and parcel of free markets. When investors know the government will permit failure, they needn’t fret about non-viable firms getting bailed out. They can properly price risk—critical for a successful bond market. And confidence grows in that market’s viability.
By permitting bigger defaults—especially among state-owned firms—China builds on its recent history of increased financial discipline—good for China’s bond market but also foreign investors trying to price risk.
As for claims more big defaults will derail China’s recovery—and perhaps the world’s—look to the marketplace to see that claim is bunk. Despite these fears, Chinese corporate bonds are up 2.3% in 2021, with much of it coming in April as debt fears multiplied. US corporates? Down -3.3%. While short term, that hints at how investors view China’s creditworthiness. Yes, some riskier areas of the market have seen rising yields amid default worries. But that is exactly what efficient bond markets do.
What about the impact on global stocks? Remember: Rising defaults have been among pundits’ most widely discussed China “risks” for years. Markets have largely pre-priced any impact. As reality proves this a false fear, relief likely provides more bull market firepower.
More defaults will come, hopefully. Count on pundits hyping each one as proof of imminent Chinese debt disaster. But China’s defaults actually signal progress for the world’s second-largest economy. They are a sign of growing liberalization and pre-pandemic policy returning, bullish for investors worldwide. China’s economy still needs lots more liberalization ahead. Some limited pain likely comes with it. But cheer it; don’t fear it.
