China and the Dangers of Debt

March 13, 2014

News this morning shows that industrial output growth in China reached a 5-year low. What lies ahead for the Chinese economy?

China’s economic growth over the last 15 years has been spectacular. But there is one aspect of Chinese growth more recently that merits concern: its increasing reliance on debt. Consider the graph below that plots China’s annual GDP per capita growth rate from 1997 onwards. China grew at a very healthy rate of 7 to 8 percent between 1997 and 2003.


During the same period its domestic private debt–debt owed by Chinese individuals and businesses–grew at a much faster rate, with the private debt to GDP ratio going from about 100% of GDP in 1997 to 125% of GDP in 2003 (see the solid line in figure below). The increasing reliance on debt for growth is a consequence of China’s ultra-low domestic consumption. The excess savings of China’s state, household, and corporate sectors are channeled into the state-owned banking sector which loans it out to finance domestic investment. This is all fine, except that a country’s private debt to GDP ratio cannot rise forever – something eventually has to give.

China got a break starting 2003. It no longer had to boost domestic demand through the creation of more domestic credit. The rest of the world – and in particular the United States – was willing to borrow hundreds of billions of dollars every year to purchase Chinese goods (among other things). The result was a rapid and dramatic increase in China’s current account surplus–the amount of cash borrowed by foreigners from China–from about 2.5% of GDP in 2003 to over 10% of GDP in 2007. In other words, instead of creating domestic debt to boost demand for its goods, China could rely on western countries such as the United States to generate demand for its goods. The result was reduced pressure on domestic debt creation, and domestic debt went down from 125% of GDP in 2003 to almost 100% of GDP in 2008.


As we show in our forthcoming book, the continued borrowing by western countries was not sustainable and by 2008 global demand for Chinese goods collapsed. China’s current account surplus declined from over 10% of GDP in 2007 to about 2% in 2011 and put severe downward pressure on China’s growth rate. How could China create new demand for its productive capacity?

The answer once again came in the form of a rapid rise in domestic private debt. The Chinese state-owned banks with explicit prodding from the government opened their spigots. The country has seen an explosive growth in domestic private debt since 2008. In fact the graph above does not do justice to the actual increase in debt because it misses the large increase in domestic debt due to the rise of “shadow banking system” in China.

The basic point is that China is looking increasingly towards higher domestic debt to sustain its growth rate. But if we have learned anything from Kindleberger, it is that such tendencies should raise concerns.

We can summarize China’s reliance on debt with another picture. The graph below plots the change in China’s net foreign assets position (an increase means that China’s lending to foreigners is increasing faster than GDP) against the change in China’s domestic credit creation (an increase means that China’s domestic debt is increasing faster than its GDP). One can see a strong negative relationship between the two: Either foreigners must increase borrowing at a faster pace than GDP, or locals must borrow faster. Of course, neither is sustainable in the long run!


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18 Responses to China and the Dangers of Debt

  1. Anonymous on March 13, 2014 at 4:56 pmi

    Given that increasing domestic debt is not sustainable, would financing through equity helps a bit? Actually I am not very familiar with Kindleberger.

  2. Patrick MacAuley on March 13, 2014 at 9:40 pmi

    I believe your first sentence should be “…the RATE OF INCREASE in industrial production in China reached at a 5-year low.”
    Industrial production in China was “only” 8% greater than last year, which is low by Chinese standards.

  3. John M. Shin on March 14, 2014 at 8:03 ami

    The Chinese Government has no other choice but to keep aiming at 7~8 per cent growth in order to placate the masses of people who have grown accustomed to 10 per cent annual wage/income growth. They are juggling hard to keep the balls in the air; fortunately, China’s sheer size — and disparate development in the east and the interior west — gives them slack to push inefficiencies to a reckoning at a future date. China is not lost — just yet.

  4. Aaron Gurwitz on March 14, 2014 at 8:36 ami

    You start with the premise that Chinese savings are very high and end by worrying about an increase in private debt. Is there someting very bad happening to the private sector’s aggregate balance sheet? If there isn’t, i’m going to wait before I start worrying about this.

    Further, before 2008 the world wanted the Chinese to move from their net exports-driven growth strategy to a domestic demand-driven strategy. Isn’t that exactly what’s happening here? I suppose it might be better if domestic demand growth were fueled by reduced gross savings rather than increase gross borrowing, but would it really be that much better.

  5. SteveB on March 14, 2014 at 8:40 ami

    OK, I see that there is a big change, and economies and economists don’t like change, but it is still 7% GROWTH — it is still growing at an amazing rate! How fast are other countries growing? So Chinese workers are now “accustomed to 10% annual wage growth.” Awww, it would break my heart if they had to get accustomed to less. I feel fortunate I got a 1% raise last year. Just because something unsustainable is correcting doesn’t mean it has to be a crisis, does it?

  6. Anonymous on March 14, 2014 at 9:24 ami

    I don’t understand. If its domestic savers who are giving money to the banks and the banks are lending it out. What exactly are the borrowers doing with that money? Why not simply create the kind of entitlements that could boost consumption. Have a social security system and a single payer health insurance like they have in Taiwan. Wouldn’t that create more domestic spending?

  7. M Wahdy on March 14, 2014 at 10:18 ami

    Seems to me that China, and her trade partners, should look to Bernanke’s playbook and build a strategy around 1- sudden deleveraging, 2- access and flow of liquidity, and 3- the role GSE’s play in providing a floor. If the partners came together sooner, rather than later, China would be able to more effectively settle its capital structure.

  8. […] Via Paul Krugman, Atif Mian and Amir Sufi give us the chart below today to chew over. It shows China’s declining trade surplus over the past decade, which authorities have effectively offset by a dramatic increase in private credit in order to boost domestic demand. The authors explain how this happened: […]

  9. […] Via Paul Krugman, Atif Mian and Amir Sufi give us the chart below today to chew over. It shows China’s declining trade surplus over the past decade, which authorities have effectively offset by a dramatic increase in private credit in order to boost domestic demand. The authors explain how this happened: […]

  10. Ariel S. on March 14, 2014 at 11:17 ami

    Great post, but consider using larger images. Giant images if possible. Its hard to read the scale as it is, plus readers can make large images smaller but they can’t make small images larger.

  11. Ariel S. on March 14, 2014 at 11:18 ami

    Nope. I take it back. Krugman used a small one but yours is just right.

  12. jcb on March 14, 2014 at 1:44 pmi

    Like some of the other commenters, I’m a little puzzled by your tone of concern, if not urgency, at the thought of a slowing of Chinese economic growth. I’m a great admirer of your articles on excessive debt and depressions (current and past), but I think that you make a misleading comparison in regards to China.

    Beginning with your first sentence: “News this morning shows that industrial output in China reached a 5-year low.” This suggests that nominal output is below that of 2009. As Patrick Macaulay writes in a comment, it’s the “rate of increase” that has slowed — to a mere 8.6%!

    The changes in the other economic indicators mentioned in the linked article — retail sales (an increase of only 11.8%!), fixed asset investment (an increase of 17.9% [no comparison offered]), GDP (increase of 7.7%)–indicate what some might call a “soft landing” in a challenging global economic environment. What other economy can match them?

    It is the absolute increase in living standards, not the rate of increase that matters. Retail sales, consumer demand, and wages are all rising (the last, mandated by the government). As long as consumption is rising absolutely, it hardly matters whether or not China’s trade surplus continues at the same relative level to GDP.

    Premier Li Keqiang’s remarks that the Chinese economy faces “challenges” are realistic statements of fact, not portents of doom. The Chinese government is trying to cool down the economy by dampening expectations, as it tries to control private and local public debt, shadow banking, and a housing bubble.

    Debt is a problem, but not as it was in the U.S., where the government didn’t own the banks and was hesitant to intervene, in some cases, until it was too late. The Chinese government has the will and resources to fund its banks and the supervision to do it relatively rapidly. But equally important, Premier Li has indicated that it is government policy to differentiate between borrowers, continuing to provide resources to strategic sectors of the economy, and by implication, allowing others to fail. The true test of policy may come in the housing sector, where (like the U.S.) investment and consumption of large numbers of people are most closely tied to rising asset values.

    Most of the economic problems noted by pessimistic observers are very real, but applying conventional Western experience (not to say dubious economic theories) is a mistake. So far, the Chinese have proven far more resourceful (and far more Keynesian) in economic practice than most countries in the West..

    • Atif Mian and Amir Sufi on March 14, 2014 at 3:01 pmi

      Yes, first sentence was a mistake. We’ve changed it. Thanks.

  13. […] Via Paul Krugman, Atif Mian and Amir Sufi give us the chart below today to chew over. It shows China’s declining trade surplus over the past decade, which authorities have effectively offset by a dramatic increase in private credit in order to boost domestic demand. The authors explain how this happened: […]

  14. Krugman’s blog, 3/14/14 | Marion in Savannah on March 15, 2014 at 6:04 ami

    […] effects of private debt, have a new blog — and it has instantly become must reading. Their latest post is about China, which is looking a whole lot like an overleveraged economy at great risk of a […]

  15. jack on March 15, 2014 at 12:38 pmi

    Not trying to put you guys on the spot, but I really would appreciate a more detailed response to JCB’s comment.

  16. buy google plus ones on March 16, 2014 at 8:55 pmi

    I agree — it’s what I had expected, given the article intro.

  17. Philip Hand on March 16, 2014 at 9:00 pmi

    I’m with the others above. This blogpost fails to deliver a convincing argument about problems in China. The argument is just “rising debt can’t go on forever, therefore PANIC”. What we need is some empirical work on what levels of debt actually cause problems; what is sustainable and what is not.

    Also, the reading of the diagrams doesn’t even seem very accurate. M&S say this:

    “The country has seen an explosive growth in domestic private debt since 2008.”

    But that’s not what the accompanying chart shows. It shows debt rising explosively *in* 2008-9, in response to the crisis that year, but after 2009 debt looks quite stable.

    “There is a trend” is not a proper argument. You need to give some indication of why that trend is reaching danger points.