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.

After a decade of rapid credit growth, China is now much more indebted than countries at similar levels of economic development. The slowdown in the economy over the past year has increased pressure on overleveraged borrowers, posing risks for the financial system. China has three main options to address these problems: use the central government’s balance sheet, readjust the fiscal balance sheet, or sell state assets. If instead Beijing chooses to simply muddle through, it faces the risk of a Japanese-style lost decade. Policymakers should embrace the debt challenge as an impetus to reform China’s fiscal system and adjust the role of government in the economy. These changes could once again set China on a path to more rapid growth. Doing so, however, would require a major shift in the Xi administration’s ideological approach to the economy.

I address this topic in a China Leadership Monitor article titled China’s Balance Sheet Challenge. Below is an excerpt from that article:

The Chinese economy is likely to recover somewhat after Beijing’s abrupt pullback from many of its most damaging policies in late 2022. China’s balance sheet challenge remains pressing and unresolved, however.

If faced with the threat of an imminent financial crisis, the Chinese government is likely to take action to defuse any immediate risks. Absent that type of acute pressure, Beijing’s inclination will be to muddle through its debt problems by providing indirect support to problem borrowers and relying on economic growth to reduce overall debt burdens gradually. China’s slowing growth trajectory and the encumbered balance sheets of many of the entities Beijing relies upon to provide bailouts mean that this approach will struggle to be effective. Moreover, if China avoids structural reforms to address its balance sheet problems, it faces the risk of a prolonged period of slow economic growth.

Even if they avoid bankruptcy, highly indebted borrowers face the difficult task of repairing their balance sheets, a project that could stretch on for years. These borrowers will be forced to reduce spending and investment, slowing economic growth, thereby reducing tax revenues for local governments and further straining their balance sheets. In the real estate sector, in particular, China faces the prospect of a negative feedback loop of lower property prices leading to less investment, less government revenue, and slower growth, which will ultimately put further pressure on property prices.

The net economic effect of many borrowers cutting spending and investment to pay down indebted balance sheets is referred to as a balance sheet recession. In this environment, tools frequently used to stimulate the economy, such as an expansionary monetary policy, do little to spur credit growth because of weak demand for new borrowing. As a result, economic growth may remain sluggish for an extended period.

To continue reading the article, follow the link below.

China’s Balance Sheet Challenge

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