For decades, the debt to GDP ratio has been widely used as the key gauge of a county’s financial vulnerability. Nevertheless, this measure has proved to be misleading. In the mid-1990s, when Japan’s gross debt to GDP ratio approached 120%, many concluded that the country was heading for fiscal ruin, which would inevitably collapse the bond market and the yen, and cause hyperinflation. What has happened since then is that this same ratio has risen to more than 250% in 2017, while Japanese government bond yields have fallen to zero. Japan has suffered decades of price deflation.
Looking around the world, the levels of interest rates for different countries are negatively correlated with levels of total indebtedness. On the one hand, countries that have borrowed aggressively – such as Japan, China and Singapore – have very low or zero interest rates. On the other hand, countries that have barely borrowed, including Brazil, Russia and Indonesia, usually pay very high interest rates. This negative correlation is highly significant, disproving the widely held notion that higher debt levels lead to higher risk premia at the macroeconomic level. How is this negative correlation explained? Interest rates are the price of domestic savings, and countries with more abundant savings almost always have lower interest rates. Moreover, every economy needs to transform its domestic savings into investment, usually through the banking system. It is inevitable, therefore, that countries with higher savings rates have lower interest rates, but higher levels of credit creation (or debt to GDP ratios), because banks need to extend more credit to move larger pools of savings into investment. This means there is nothing wrong with high-saver countries having high debt to GDP ratios.
Breakdown of Chinese debt by entities (% GDP)
Sources: Beyond Ratings, IMF
The fundamental problem with this ratio is that it only provides a narrow snapshot of an economy’s debt picture. Debt is a stock concept, while GDP is a flow. The ratio tells you more about how much of an economy’s accumulated savings have been allocated via the debt channel. It does not tell us anything about a country’s net asset position. Nor does it provide any information on debt-servicing costs or the mix of local versus foreign currency-denominated debt. As such, the debt to GDP ratio gives us almost no information on a country’s ability to sustain its debt. IMF calls for China banks to boost capital buffers. In recent years, the rapid escalation of China’s credit to GDP ratio has been watched keenly by the investment community. Many predict that a debt crisis in the country would be the next big event that would bring down the world economy and global financial markets.
China’s domestic saving rate was 46% in 2016, which amounts to c. USD 6,000 billion of new savings each year. This vast pool of savings primarily relies on state-owned banks for allocation. It is therefore inevitable that the country has a high credit to GDP ratio. Furthermore, so-called credit risk in China is, in fact, sovereign risk. The Chinese government often relies on bank credit to finance government stimulus programmes. In 2009, Beijing launched a fiscal package worth more than USD 600 billion to combat the effects of the global recession that followed the global financial crisis. Subsequently, Chinese bank credit growth climbed steeply, lifting the credit to GDP ratio to new highs. In essence, the Chinese government was using credit expansion to finance fiscal stimulus. This was a credit-based equivalent of the Troubled Asset Relief Program in the United States. There, fiscal stimulus programmes are financed by increasing public sector debt. In China, they are often funded by depositors. China has a chronic current account surplus and has been a net creditor to the rest of the world for decades. Beijing’s outstanding public sector debt, valued at about $4tn, is dwarfed by the vast assets controlled by the various levels of governments. Therefore, China’s sovereign risk is extremely low. Importantly, the balance sheets of the Chinese state-owned banks, the government and the People’s Bank of China are all interconnected. Under these circumstances, a debt crisis in China is almost impossible in the short term.
Julien Moussavi, Head of Economic Research