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Credit growth in China during and since the global financial crisis period has been elevated. This rightly has raised concerns over the possibility of growing risks in the financial system. Rapid credit growth does not always result in a financial crisis, but most crises are preceded by rapid credit growth. Under some measurements, credit in China is now growing at a pace strongly associated with subsequent financial distress.
Beyond the rate of credit growth, the level is also important. There is a strong positive relationship between credit and per capita income. This explains why not all instances of credit growth are bad. A country experiencing rapid credit growth may simply be experiencing “catch up” financial deepening as it converges to levels of credit prevalent among peer countries. This, however, is not an explanation for the current spurt of credit growth in China, as its level of credit is high relative to peer countries.
Though private sector credit in China is high relative to countries with similar per capita income levels, it’s been this way for several decades. As far back as 1993, China’s credit-to-GDP was close to 100 percent. It was even more of an outlier back in per capita terms given the extremely low base of incomes in that period.
What accounts this long-term discrepancy between China’s per capita income and credit levels? There are two main factors at work.
First, countries with small equity markets have higher levels of credit. Intuitively this makes sense. If a country does not have well-developed equity markets, new financing will go through credit rather than equity channels. Thus, for any given level of financing demand in an economy, countries with underdeveloped equity markets will have higher credit levels.
The chart below looks at the relationship between the total assets of deposit money in banks versus listed company assets as a rough proxy for credit-dominated financial systems (rather than equity-dominated). This measurement partly explains why credit is so high in China.
The second and principal explanation for China’s persistently high levels of credit is misclassified fiscal costs. In the 1980s, the soviet-style monobank was dismantled and the four large commercial banks were established. During this period state-owned enterprises stopped receiving direct grants from the government and instead borrowed from the newly created banks. These state-owned enterprises provided a wide array of social services including schools, housing, and healthcare. In most countries these expenses fall under the government’s purview and are financed with fiscal resources. However, in the Chinese system these expenses fell to state-owned enterprises and were financed in large part through borrowing. This distortion was reduced when state-owned enterprise reform began in the late 1990s and state-owned enterprises significantly cut the amount of social services provided to workers.
Over the past decade, however, a new source of distortion has grown through local government financing platforms. These special purpose vehicles borrow on behalf of local governments to finance local investment projects, like infrastructure. This can be traced back to the central government’s prohibition on letting local governments borrow directly. Because these entities borrow as corporations, their debt is included in the credit-to-GDP statistics. If China’s fiscal system was rationalized, most borrowing to finance these projects would be done directly by local governments and therefore would not be included. If local government financing platform loans (9.5 trillion) and bonds (1.4 trillion) are reclassified, China’s private sector credit-to-GDP ratio falls by 20 percent.
China’s credit levels are high, especially relative to its per capita income. This has been the case for several decades and China was even more of an outlier in the past. Its status as an outlier is partially explained by its bank-dominated financial system and misclassification of fiscal costs as corporate borrowing. These factors argue for paying more attention to the rate of credit growth in China instead of the overall level. China’s credit growth, especially non-loan financing, has been growing at an excessive rate since 2009. Tackling this problem, rather than fretting about the overall level, should be the primary concern.