by Aidan Kang, CFA
Senior Writer
UPDATED: February 20, 2023

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.

China's GDP per capita growth

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). Even today, Americans have no problems with the number of loan options available for them to choose. 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.

China's current account to GDP

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!

Change in net foreign assets