Striking a Balance Between Debt Growth and Debt Risk

Abstract: Over the past 20 years, the share of new debt by the government (including local government financing vehicles, or LGFVs), non-LGFV enterprises, and households in the total new debt has roughly been 4:4:2. During the industrialization peak before 2012, capital-intensive industrial enterprises’ debt-financed investments were the main contributors to new debt. From 2012 to the pandemic, LGFVs’ debt-financed investments, and household debt for home purchases and consumption were the primary sources of new debt. After the pandemic, manufacturing and small and micro enterprises have contributed more to new debt.

Debt has three main functions: The conversion of savings into investments; Smoothing of consumption over time to improve personal welfare; Creation of financial assets and social purchasing power. The more debt created by a society, the more financial assets and stronger purchasing power it supports.

From an aggregate perspective, China has not created excessive debt. Debt growth has not resulted in excessive financial assets and purchasing power, as reflected in China’s average low inflation rate over the past decade and frequent encounters with insufficient aggregate demand.

Debt ratios are not suitable for evaluating debt risk. The desirable total debt growth rate should align with the core inflation target of 2%. The way to reduce leverage and debt burden lies in low interest rates and moderate inflation levels. Government debt should actively balance the fluctuations of private sector debt.

The debt repayment capacity of China’s household and government sectors is sufficient. The more prominent debt risks come from LGFV debts, real estate enterprise debts, and debts of manufacturing and small and micro enterprises.

To resolve LGFV debt risks, the pace needs to be managed carefully, with a multifaceted approach. Resolving real estate enterprise debt risks cannot rely solely on the enterprises themselves or local government efforts; macroeconomic authorities need to step in and address the issue promptly. Attention should be given early to the debt risks of manufacturing and small and micro enterprises to prevent these sectors from becoming new major sources of debt risk following the LGFVs and real estate enterprises.