The End of China’s Magical Credit Machine
China’s economic growth will slow significantly over the next decade. One of the most important drivers of this slowdown is the unwinding of an unprecedented credit bubble. China’s financial system simply won’t be able to generate the same levels of credit growth that it has in previous years. This means that Beijing will have far less control over the direction of its economy than it has in the past. Growth in total societal financing (TSF), a measure of funds provided by the financial system to the real economy, is at all-time lows, and other credit metrics are decelerating. Over the next decade, we expect rates of credit growth in China to fall below 10%, with knock-on effects for investment growth and the broader economy. Credit growth is under pressure for three main reasons:
- Credit demand is slowing sharply, because households and corporates have reined in their expectations for economic growth.
- Lenders are becoming more cautious in response to rising credit risks in several asset classes, as implicit government guarantees for borrowers lose credibility. This is particularly apparent in lending to the property sector.
- Credit supply is constrained by the massive size of China’s financial system, and the difficulties of maintaining high rates of credit growth while complying with regulations related to capital requirements and loan loss provisions.
Pretending Prevents Extending
China’s economy depends on investment, which depends heavily on the flow of new credit to fund that investment. Investment (gross fixed capital formation) makes up around 42% of China’s GDP, far above other economies at China’s stage of development. Savings rates remain extremely high, putting downward pressure on household consumption. Significant changes in the direction of China’s credit impulse can meaningfully change the direction of the economy and global cyclical signals, with recent research by the Federal Reserve highlighting the importance of China’s credit conditions.
In the past, China’s financial system grew much faster than the real economy: credit grew by 18.1% on average between 2007 and 2016, and the banking system added $26.8 trillion in assets over that period, compared to “only” $7.6 trillion in GDP growth. Credit expanded rapidly because financial losses were unthinkable because of implicit government guarantees for both borrowers and lenders. In essence, markets assumed that Beijing would always intervene to prevent financial instability. (See Credit and Credibility for a much more detailed discussion of this argument.) This led to a dramatic expansion of China’s shadow banking system, which extended large volumes of credit to both property developers and local governments. China’s authorities did not consider moral hazard a problem. On the contrary, it was a core element of their strategy for expanding the economy.But China’s financial system can no longer generate the same pace of credit growth as in the past. The system is simply too large, at $53 trillion in assets—over half of global GDP—to grow at double-digit rates indefinitely. The upper ceiling for credit growth over the next decade is probably 12-13%, and in most years, it is likely to be much lower. This means that China’s financial system will no longer be able to serve as a shock absorber for the real economy, cushioning losses for enterprises and projects that cannot service their debts out of profits or operating cash flow.
The unwinding of this dynamic, under which quasi-fiscal investments were pumped into the economy without an expectation of financial returns (and loans rolled over year after year) is now a key constraint on China’s future economic growth. Declaring losses, cutting off non-performing companies and projects, and writing loans off within the banking system would reduce banking system profits, which are the only consistent source of capital for the banks, and key channels of financing for investment in China’s economy. It is far easier to simply roll over the loans and keep local government projects and companies operating, even if that means credit continues flowing to low-productivity industries. Pretending these loans are still performing prevents Beijing from extending the life of its previous growth model, with constraints building year by year.
As credit growth continues slowing, interest rates must trend lower to allow companies and local governments to manage their previous debt burdens. A larger proportion of a smaller pool of credit will be used to manage debt servicing costs, rather than fund new investment, and economic growth will slow as the costs of past debts crowd out future private sector investments. This is not necessarily a recipe for a full-blown financial crisis, although that possibility cannot be ruled out. But sand in the gears of China’s credit machine does portend slower economic growth over the next decade.
Credit Demand Under Pressure
Overall credit demand in China is weakening, consistent with the economic slowdown. Throughout the pandemic, businesses have grown increasingly reluctant to borrow and invest, given the uncertainty of operating conditions. Moreover, the crackdown on education technology firms and Internet platform companies had a significant impact on private sector confidence.
There have been a number of warning signs in recent months that corporate credit demand is on the wane. First, short-term (1-month) bill financing rates have plummeted close to zero in most months over the past year. These rates fall when banks struggle to find borrowers at close to benchmark interest rates, and need to bid for lower-return assets in the secondary market. In normal times, bill financing rates have only fallen to zero toward the very end of the month, but in December, they stayed at zero for almost the entire month. More worrying was the fall in 3-month bill financing rates to zero in the final week of December, suggesting banks’ expectations for credit demand in Q1 2023 are already very weak.
Second, throughout the past year, there has been a persistent gap between actual money market repo rates and the policy rates at which the PBOC extends financing via reverse repos. Current 7-day repo rates are still around 1.6%, while the PBOC offers 7-day financing at 2.0% (Figure 2). This indicates a consistent weakness in credit demand, when banks cannot find borrowers and must park the excess liquidity in the interbank market, keeping money market rates below policy rates.
Household credit growth has also declined sharply throughout the pandemic, but particularly since the slowdown in the property market began. Households are repaying mortgages faster than they are being extended, and the overall pace of household credit growth has slowed to a new all-time low of 5.7% y/y as of November. The latest PBOC quarterly survey, conducted in December, suggested Chinese families now see an even weaker outlook for jobs and income growth, and the proportion of survey participants choosing to save more in the future rose to yet another record high of 61.8% (choices were to save, consume, or invest more). At the end of 2019, before the COVID-19 outbreak, the share of survey respondents who were inclined to save stood at 45.7%. It has been rising since the end of 2017, as consumer credit has declined as part of a deleveraging campaign. The pandemic merely accelerated this process.
Most corporate credit demand this year will be driven by infrastructure projects and local government borrowing. This includes 630 billion yuan in pledged supplementary lending (PSL) from the PBOC between September to November, 740 billion yuan in policy bank financing for infrastructure projects, and an additional 800 billion yuan in loan quotas for policy banks. The PBOC said in its Q3 monetary policy report that commercial banks also provided 3.5 trillion yuan in credit lines to supplement these policy bank financing tools to fund infrastructure projects. Still, this is not enough to offset the obvious weakness in private sector borrowing, both from households and corporates. TSF growth slowed to just 10% at the end of November and is likely to be in the single digits, for the first time on record, in December 2022.
The end of China’s zero-COVID policies could well support credit demand among private businesses over the coming year. But the slowdown in credit demand is a longer-term phenomenon, consistent with the structural slowdown of the economy, and weakness in the property sector.
Lenders Risk-Averse Given Rising Defaults
On top of the decline in overall credit demand, lenders within China’s financial system have become far more reluctant to lend over the past five years, and particularly since the property sector began weakening. This is primarily because credit risk has begun spreading into more and more asset classes since China’s deleveraging campaign to manage the shadow banking sector began to show its effects in 2017 and 2018. Overall credit growth has slowed, of course, which leaves more and more borrowers cut off from refinancing and at greater risk of default.
But the broader trend of rising credit risk is unprecedented, because it reflects the end of a decades-long period in which moral hazard permeated China’s financial system. Until the deleveraging campaign, defaults in any Chinese asset class were extremely rare. The financial system expanded quickly based on the widespread expectation that both borrowers and lenders were backed up by implicit guarantees. As a result, anytime there was a credit event in China’s financial system—such as the interbank market crisis of June 2013—the natural response from Chinese investors was a “flight to risk” rather than a “flight to quality.” Most investors saw the government’s aversion to perceived political instability and assumed they would be bailed out, even when investing in stocks, as was the case during the 2015 equity boom and bust. Now, investors can no longer count on the government as a backstop. In an article in early November, PBOC governor Yi Gang wrote that individuals and firms would have to manage financial risks on their own from now on.
Lending to peer-to-peer networks became risky in 2017 and 2018 as many of these speculative lenders defaulted, generating numerous protests among angry investors facing losses. Then small banks such as Baoshang and the Bank of Jinzhou began to fail in 2019. Corporate bonds defaulted in far larger volumes starting in 2020. Then even local government state-owned companies started to default, as Yongcheng Coal’s default in November 2020 raised the risk that local governments could shift priorities and resources away from repaying bondholders. Trust companies showed the first signs of weakness in property-related credit, as more and more faced defaults starting in 2020 and early 2021. Well before Evergrande’s financial distress, property developers were already defaulting on their debt. (See Feb 2021, “China’s Financial System is Cracking—What Next?”) Many more followed after the imposition of the “three red lines” and the dramatic economic slowdown of 2022.
Throughout the deleveraging campaign, China’s shadow banking system—most of which consisted of “channel business” from banks to third party asset managers—has contracted, creating new credit risks among the shadow banks’ traditional borrowers. These included lower-income households accessing mortgages and down payments from peer-to-peer lenders, as well as property developers and local government financing vehicles (LGFVs) borrowing from trust companies. Over the past three years, loan officers and bond investors began determining credit risks based on the perceived stability of local governments backing certain companies, a trend we called “geographic counterparty risk.”
As a result of these rising credit risks over the past five years, banks are far more reluctant to lend in the same volumes as in the past, because they cannot do so and minimize credit risk at the same time. Several attempts at window guidance to encourage banks to increase lending this year have been unsuccessful, with banks simply channeling more resources toward companies considered safe, notably state-owned firms, or to “safer” local governments. This risk aversion is a more conventional response to a slowing economy, and it is increasingly apparent within China’s financial system.
Capital and Regulatory Constraints Limit Credit Supply
Banks have also faced more mechanical and regulatory constraints to expanding credit in recent years. China’s banking system is extremely large, but not very profitable. Aggregate returns on assets have remained extremely low in the last five years, below 1%. This is problematic because the banking system needs to generate large amounts of new capital every year in order to continue to expand asset books at the same rates. Retained earnings are the only realistic source for adding to banks’ capital bases—some banks can issue new shares or issue subordinated debt, but for smaller banks that lend to local governments and property developers, access to capital markets is limited.
This explains banks’ difficulties in writing off large proportions of non-performing loans with the hope of improving credit efficiency: to do so across the entire banking system would decimate profitability. As a result, banks have only written off an average of 0.34% of assets annually over the past five years. Much of the expansion of the shadow banking system from 2013 to 2016 was designed to work around requirements for capital risk weightings on loans, by reclassifying assets in other forms, such as “interbank placements” and “investment receivables.”
Of course, regulators could encourage faster credit growth by relaxing capital requirements for banks. But this would likely make the entire system far riskier, and more vulnerable to a banking crisis and insolvencies. One could argue that banks’ balance sheets simply do not matter, as equity capital has no meaningful role within a state-owned banking system. But China must pretend that they are important because shares of banks have been listed on public exchanges and sold to both Chinese and foreign investors. The perceived stability of the banks is important if Beijing wants to continue to play a part in the international financial system and seek access to foreign capital.
The End of China’s Great Ball of Money
There are several implications for China’s economy from the broader slowdown in overall credit growth. First, Beijing is losing control over a critical policy tool which gave it outsized influence over the financial system. If Beijing can no longer provide the guarantees that ensured lending was safe, then financial institutions must protect themselves and reduce their exposure. Lending will become increasingly concentrated in a group of state-protected borrowers and quasi-fiscal institutions at the local government level—those that still feature more explicit government guarantees. Beijing’s capacity to encourage private sector investment will be weaker, as state-directed credit will crowd out private borrowing.
Second, this has major implications for asset markets as well. For years, the large expansion in credit had created a “great ball of money”. Surplus liquidity sought returns within China’s economy—flowing into equities, then to property, then to commodities, and back again. The slowdown in credit growth reduces surplus liquidity in the financial system that could fund speculative investments. China’s liquidity-sensitive markets and industries may be operating in the future with far less money swirling around the economy, particularly if there are no meaningful changes in credit allocation.
Third, the slowdown in credit accelerates the reckoning China faces with its existing growth model. Weaker credit growth means less credit available for refinancing old debts and keeping quasi-fiscal local government infrastructure lending alive. The economic growth generated from a marginal yuan of new credit will be much smaller over time—unless, and only unless, structural reforms within the economy allow China to transition toward a less credit-intensive and more private sector and consumption-centric growth model. Whether by active policy choice or the gradual pressure of rising debt, investment-led growth is finished in China. Whatever the future brings for China’s economy, it will not look anything like the past.
 William L. Barcelona et al, “What Happens in China Does Not Stay in China,” Federal Reserve International Finance Discussion Papers, No. 1360, November 2022, https://www.federalreserve.gov/econres/ifdp/files/ifdp1360.pdf.