Prevailing Winds is a China-focused blog written by Nicholas Borst, Director of China Research at Seafarer. The blog tracks the economic and financial developments shaping the world’s largest emerging market. Learn more about Prevailing Winds.
Foreign currency borrowing is the “original sin” of emerging markets and investors are rightfully wary when countries begin to accumulate significant amounts of external debt. External debt involves borrowing from overseas entities and is often denominated in a foreign currency.1 In contrast, locally held debt is classified as internal debt and is usually based in the local currency. China is now the emerging market with the largest stock of external debt and this fact has attracted significant concern. However, a closer analysis reveals that China’s external debt is both less risky than it initially appears and not large relative to the size of the Chinese economy.
Why Foreign Currency Debt is Dangerous
Companies in emerging markets borrow in foreign currencies for a variety of reasons, including to gain access to cheaper financing and to support overseas investments. Most overseas borrowing happens in U.S. dollars, with smaller amounts occurring in other currencies such as the euro, yen, and pound. Foreign lenders often prefer to lend in one of these currencies to reduce the risk that exchange rate movements will erode the value of the debt.
While lenders are eager to avoid taking on currency risk, this simply means that the risk is transferred to the borrowers. If the borrower’s local currency depreciates significantly, the real debt burden increases as more local currency must be converted to the foreign currency to satisfy repayment. Sudden and large movements in exchange rates can rapidly force borrowers into default. Emerging market companies often prefer to borrow locally to negate this risk, but the requirements of a transaction (such as buying overseas assets) or the availability of financing sometimes mean that foreign currency borrowing is the best or only option.
This dynamic has been at the heart of the many foreign debt crises that have plagued emerging markets. The Asian Financial Crisis was in large part related to an unsustainable increase in the real debt burden of foreign borrowings after the Thai baht and other Asian currencies depreciated against the U.S. dollar. It is with this history in mind that investors grow concerned when emerging markets begin to take on large amounts of foreign currency debt.
How Much External Debt Does China Have?
Claims about the size of China’s external debt vary significantly. Some analysts put the figure at as much as 3 trillion U.S. dollar (USD) equivalent, nearly as much as China’s entire foreign exchange reserves. If these figures are correct, China is highly reliant on foreign borrowing and a devaluation of the renminbi (RMB) could have disastrous consequences. However, to understand the true extent of the risks, it is necessary to look at both the total amount of debt and the composition of borrowers.
According to the official statistics from the State Administration of Foreign Exchange, China has around 1.91 trillion USD-equivalent in external debt as of September 30, 2018. Importantly, external debt measures all claims on Chinese borrowers from abroad, even those in renminbi. Around 35% of China’s external debt is denominated in renminbi, leaving around 1.24 trillion USD-equivalent in foreign currency debt, most of which is in U.S. dollars.2 This analysis will focus on all external debt (including renminbi debt) because each subcategory of external debt is not disaggregated by currency. Figure 1 shows the share of China’s gross external debt in all currencies owed by banks, corporates and non-bank financial institutions (NBFIs), the central bank, the government, and intercompany lending.
Banks: Chinese banks account for nearly half of China’s external debt, around 900 billion USD-equivalent. However, there are several mitigating factors which reduce the riskiness of this debt. First, more than half of the external debt of Chinese banks is in the form of currency and deposits. Deposits are generally a stable and low-cost form of financing. Second, the amount of external debt held by Chinese banks needs to be balanced against their external assets. Over the past few years, Chinese banks have emerged as large overseas lenders. This boom in overseas lending is driven by the Belt and Road initiative and by Chinese firms expanding abroad. As of September 2018, Chinese banks had a net positive of 50 billion USD-equivalent in external debts.3 The risks from the external debt owed by Chinese banks are lessened by the fact that, as a whole, they are larger lenders than borrowers.
Government and Central Bank: Another 229 billion and 40 billion USD-equivalent of China’s external debt is linked to the government and the central bank, respectively. Most of the increase in the government’s external debt has come via greater purchases of renminbi-denominated government debt by foreign investors via the Bond Connect and other channels. The Ministry of Finance (MoF) has also issued some U.S. dollar debt in Hong Kong in order to improve the yield curve for offshore borrowing by Chinese corporates. The government’s external debt is low risk because it is mostly denominated in RMB and represents a small portion of its total balance sheet – around 10%.4 The People’s Bank of China has external debt in the form of outstanding foreign currency, special drawing rights (SDR), and a few other small items. These amounts are dwarfed by the central bank’s more than 3 trillion USD-equivalent in foreign exchange reserves.
Corporates and Non-Bank Financial Institutions (NBFIs): Chinese corporates and NBFIs have over 500 billion USD-equivalent in external borrowing. This is a large amount, but it is tempered by the fact that 59% of the debt is in the form of trade credit, which tends to be relatively low risk because it is linked to the sale of goods. Only 13% of the total is accounted for by the riskiest type of borrowing, short-term loans and bonds. Some of this short-term borrowing may be to support working capital needs and therefore is not particularly worrying. While there may be clusters of risks among certain borrowers, Chinese companies and NBFIs are generally not reliant upon foreign financing. The 521 billion USD-equivalent in external borrowing is equal to less than 3% of the total credit extended to non-financial corporations.5 External borrowing is not an important source of finance for most Chinese companies.
Intercompany Lending: The final category, intercompany lending, accounts for around 230 billion USD-equivalent of China’s external debt. Intercompany lending is classified as a type of foreign direct investment and consists of debt liabilities to subsidiaries and affiliated companies. An example of this type of activity would be a Chinese company issuing debt securities via offshore entities and then transferring the proceeds to their onshore parents via intra-company loans. Assessing the risks of this type of lending is difficult because the information regarding the terms and conditions of the debt is often not made public. The risks may be lower in some cases because the debt is owed within a corporate group and therefore more likely to be restructured if necessary. The more significant risk may be held by the offshore subsidiaries who are directly exposed to foreign investors.
Comparison to Other Emerging Markets
While the analysis above shows that much of China’s foreign debt is less risky than it initially appears, the aggregate amounts are still quite large. The Bank for International Settlements tracks foreign currency debt by non-bank borrowers across a variety of emerging markets. As shown in Figure 2, China has the largest amount of foreign currency debt by a wide margin.6
A sense of proportion, however, is critical for this type of analysis. The Chinese economy is nearly as large as the rest of the economies in the chart combined. When shown as a percentage of gross domestic product (GDP), as in Figure 3, borrowing by Chinese companies is revealed to be significantly below the levels seen in other emerging markets.
Weighing the Risks
None of this analysis should be taken to imply that specific Chinese borrowers are not overleveraged with respect to external debt. Where risk does exist, it lies primarily with Chinese companies and NBFIs who are net borrowers, as opposed to banks which are net lenders. Taken as a whole, the Chinese economy is not particularly reliant on foreign borrowing, especially when compared to other emerging markets. The Chinese economy is overleveraged in many respects, but the country’s credit boom has been domestic in nature.Nicholas Borst Seafarer Capital Partners, LLC
The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
- The International Monetary Fund defines an external debt as “the outstanding amount of those actual current, and not contingent, liabilities that require payment(s) of principal and/or interest by the debtor at some point(s) in the future and that are owed to nonresidents by residents of an economy.” See “External Debt Statistics: Guide for Compilers and Users,” International Monetary Fund, 25 June 2003.
- Wind Information. Data as of 28 December 2018.
- Wind Information. Data as of 28 December 2018. The total net external liabilities of the Chinese banking sector equaled 203 billion USD-equivalent. However, that amount is due to equity in Chinese banks held by overseas investors and is not classified as debt.
- “People’s Republic of China 2018 Article IV Consultation,” International Monetary Fund, 26 July 2018.
- “Total Credit to Non-Financial Corporations,” Bank for International Settlements, 16 December 2018.
- The Bank for International Settlements (BIS) series “Total Credit to Non-Bank Borrowers by Currency of Denomination” provides a comparison of USD, EUR, and JPY borrowing across many different economies. For countries where these currencies are not the domestic currency, such as China, the amount consists of three main components: international debt securities, cross-border bank loans, and locally-extended bank loans in foreign currency. See “BIS Global Liquidity Indicators: Methodology,” Bank for International Settlements, 18 April 2018.