China's Debt Bomb

From China Evergrande to the Belt and Road Initiative

We have for some time now been following the China Evergrande story and more broadly the unfolding collapse of the property development industry in China. This is in part a story of contemporary domestic public policy—the Chinese government is attempting deliberately to deflate the domestic property bubble in an effort to promote “common prosperity”, while limiting collateral damage to the Chinese financial system and to the rest of the economy. But the story is not just about impending debt defaults among highly leveraged property developers; it is also (and more importantly) about undisciplined capital investment over several decades by private corporations and their customers, facilitated by direct and indirect government action at various levels. I have referred to this story as the “China debt bomb”, which is the aspect of the story that the financial press has focused on, but I think the full story may be less about the use of debt to fund capital investment than it is about the merits of the capital investment itself. If China Inc had wisely invested all this money, in property development or otherwise, we wouldn’t be so focused now on how they financed it.

But how big is the Chinese property development problem really?

To address this question, let’s focus on the amount of debt incurred, recognizing that this will not give us the full picture. (Capital investment projects typically get funded with a mix of debt and equity, but sometimes as here most of the funding comes from debt.) According to estimates from Nomura, Chinese property developers have incurred $5tn or so of total debt, an amount which has doubled since 2016 and is about equal to the entire GDP of Japan, the third largest economy in the world, and one-third of so of Chinese GDP. About half of the property development sector debt is held in the form of domestic-currency bank loans and another 10% or so is held in the form of foreign currency (USD) debt issued by off-shore affiliates. [I presume the balance consists of domestic currency bonds, but it may also include some other debt-like liabilities, eg customer deposits.] The offshore bonds issued by property development companies are now trading at deep discounts to face value—the average sector yield is over 20% and in some cases individuals bonds trade at 25% or less of face value—and a growing number of property development bond issues are now in default or will be shortly. Chinese banks with lending exposure to the sector have also begun increasing their loan loss reserves in anticipation of rising delinquency and default rates, although it is unclear to what extent future credit losses will impact the banking sector. (Offshore bonds are structurally subordinated to onshore bank and bond debt, which have prior claims to parent company assets and cash flow.)

Concerns over Chinese debt are not limited to the property development sector, of course, but the property development sector is likely the biggest (and most widely publicized) source of current concern in the Chinese debt markets. Total national debt in China amounts to something like $45-50tn, equivalent to about 300% of GDP. Unlike in the US and other developed economies, however, the vast majority of Chinese debt is owed not by the central government but rather by private entities, primarily corporations. (China is a communist country, but one with a very vibrant private sector.) Over half of total Chinese national debt (say $24tn or so) was issued by corporations, both private and state-controlled, in the form of bank loans, bonds and other borrowings. The total amount of outstanding domestic loans at Chinese banks is about $20tn, not all of which was lent to corporations, and the size of the domestic corporate bond market is about $6tn. So I think it is fair to conclude that $5tn of property development debt, half of which is owed to Chinese banks, is significant, even in the context of the highly leveraged Chinese financial system.

The Chinese “debt bomb” is not entirely a domestic story however. For years now the Chinese government has also employed aggressive financial strategies to execute its international development efforts, including the large and controversial program known as the Belt and Road Initiative (BRI). The BRI is a core element of China’s foreign policy, the details of which have been largely shrouded in secrecy, until now that is.

Last week, W&M’s AidData project published new research documenting in detail the scale and scope of China’s BRI, including much new information on how China’s BRI projects are being financed with “hidden debt”. The publication of the AidData research is a major coup for W&M, where cutting edge faculty-student research has become a way of life, but more importantly it adds significantly to our understanding of what China has been up to in the international economic development sphere. Until the publication of the AidData research, it was apparently very unclear to global policymakers and international development lenders exactly how much money China has put into the GRI and how they have structured the associated financing. In this context, the reference to “hidden debt” relates not so much to how China has funded its expenditures, but rather to the less than transparent impact of the project debt on the leverage and credit quality of the countries which have been “hosting” the projects.

I won’t go into the details of the AidData research, although I have included here and below links to a recent Economist article which summarizes the research as well as to the AidData website from which you can download the original report. I strongly encourage you all of you to read at least the Executive Summary of the Report. The AidData report is interesting and important work, and it will make those of you from W&M even more proud of your alma mater, and justifiably so.

To understand the AidData report, however, it would be helpful to have at least a general understanding of how “project finance” works, Project finance is different in important respects from the more traditional corporate finance structures we have been discussing in the domestic property development sector. Consider for example a new energy development project in a low-income but resource-rich country (Country X), which does not have the internal financial or other resources to undertake the project on its own. How can Country X get this project built and funded? Well, one way is through the use of project financing structures. Country X can shop the project to experienced public or private multi-national corporations (MNCs), who will compete to act as the designated operating partner of Country X and commit to design, build, finance and operate the project with minimal financial commitment from Country X (other than the contribution of resource development rights perhaps). The debt used to finance the project can be raised in the form of bank loans and/or bonds, but importantly the project debt will be structured an obligation of the project entity rather than as debt of the project sponsors (Country X and the MNC). When structured in this way, the project debt will be “non-recourse” (and off-balance sheet) to the project sponsors, who in the event of a failed project risk the loss of their cumulative equity investment but who are not liable for the debt itself. The project debt is “hidden” not on the books of the project entity, or of the lenders, but on the books of the project sponsors.

There is nothing particularly controversial about traditional project financing as such. It is a long-established and widely used form of structured financing which mitigates financial risk for the project sponsors and thereby facilitates the construction of certain types of high-risk projects. The lenders to the project take on project-specific risk, without direct financial recourse to the project sponsors, but they do so knowingly and with compensation commensurate with the risks they are taking on. But as with all forms of complex financing, the devil is in the details, and it is possible that project financing structures may leave more cost and risk with one or more of the sponsors than might initially appear to be the case, or that would have been the case with other alternative funding structures (including direct grants or loans from international development organizations).

And this may be happening with China’s BRI projects. Consider for example the case of the China-Laos Railway, highlighted in The Economist article cited above. The direct debt funding associated with the project reportedly totals about $3.6bn. This borrowing is not reflected as a liability on the balance sheet of the Laos government, which did not itself borrow the money. Nor will the loan (asset) and associated funding (liability) be reflected on China’s sovereign balance sheet if the loans were made by non-consolidated affiliates of the Chinese government (eg state-controlled banks) or other independent lending entities. [I don’t know how China structured the lender arrangements.] Because the project itself is likely not a public borrower (eg the issuer of publicly traded bonds), its own financial statements will not been publicly disclosed either. So even though this is a very large and important project, certainly for Laos, until now the international development community has known very little about the magnitude of the project or the structure of its financing. Hence the reference to “hidden debt”.

But why should the government of Laos, its creditors or international lending organizations care about the details of the railway project financing, given that the debt is structured as non-recourse and off-balance sheet to Laos? They should care because this is a large and strategically important infrastructure project for the small country, the control of which is largely in the hands of China, on which Laos already relies heavily for financial (and other) support. And because the terms of the project financing have not been fully disclosed, it will be unclear to these concerned parties (or others) what impact the project might ultimately have on Laos’ own financial position or credit capacity. Laos’ sovereign debt currently totals about $6.6bn (60% of GDP), about half of which is owed to China. This is not a particularly comfortable financial position for Laos, a very poor country. But the picture could get easily much worse, and Laos’ dependence on China much greater, in the event of future operating or financial problems on the railway project. Laos may not be legally liable for the project debt per se, but it almost certainly has some amount of contingent financial liability to the project entity (and indirectly to China), and these contingent obligations may well be material not just to the project but also to the financial position of the entire country. And by the way, the Laos economy will have grown reliant on the railroad, so it can hardly just walk away.

The China-Laos Railway project is just one of over 13,000 projects identified by the W&M AidData which China has built over the past 18-years, primarily in Asia and Africa. These projects were financed with over $800bn of debt extended or arranged by China, the details of which have not previously been well known to the international development community. It is quite possible that what W&M has uncovered is only the tip of the BRI iceberg, but even if this is not the case $800bn is still a big deal, particularly for the less developed “host” countries in which these projects are being built.

I don’t have any idea how China’s BRI will play out over time, or how the US and other large countries will respond strategically or financially, but watch out for more news and possibly some fireworks. And next time it may be entire countries, not just a few highly levered property developers, which go bust and turn to Beijing to clean things up.

Links:

Laosy debts: A new report digs into China’s labyrinthine foreign loans, The Economist, 9.30.2021

China’s Development Finance, W&M AidData Report 9.29.2021