In the past 200 years, there have been more than 250 cases of sovereign-debt default and 68 cases of domestic-debt default. None of these was an isolated incident. Indeed, such defaults — combined with factors such as large current account or fiscal deficits, overvalued currencies, high public sector debt and insufficient foreign exchange reserves — have always triggered financial crises, from the Mexican peso crisis in 1994 to the US subprime mortgage crisis in 2008.
Since China’s era of reform and its opening up began, the country has experienced three instances of large-scale public-finance problems. In the late 1970s, the country faced a debilitating fiscal deficit. In the 1990s, its corporate sector was plagued by “triangular debts” (when a manufacturer that has not been paid for its product is unable to pay its suppliers, who in turn struggle to pay their suppliers). Later that decade, financial institutions were burdened by bad debts generated by state-owned enterprises. Now China is experiencing a fourth instance of elevated debt risk, characterized by high levels of accumulated local-government and corporate debt.
China’s national balance sheet, which boasts positive net assets, has garnered significant attention in recent years. However, in order to assess China’s financial risk accurately, policymakers and economists must consider the risks that lie in the country’s asset structure — and the liabilities not included on its balance sheet.
The current problems are rooted in the government’s response to the 2008 global financial crisis. The first round of fiscal stimulus, supported by credit easing, led local governments and the financial sector to increase their leverage ratios. As a result, by 2010, China’s overall leverage ratio had risen by 30 percent.
In 2011, local-government debt totaled 10.7 trillion yuan (US$1.7 trillion), with only 54 of more than 2,500 county governments debt-free. Debts incurred by local government investment vehicles (LGIVs) totaled almost 5 trillion yuan — 46.4 percent of overall debt.
By the end of 2011, China’s Treasury-bond debt stood at 7.2 trillion yuan, and its ratio of foreign debt to foreign-exchange reserves reached 21.8 percent, having grown by 27 percent since 2010. However, this remains well below the widely recognized danger threshold of 100 percent.
Likewise, China’s debt/GDP ratio is rising, though it remains within the “safe” boundary of 60 percent. At the end of 2011, China’s central-government debt amounted to 16.5 percent of GDP and overall government debt totaled 38 percent of GDP.
So, judging from its balance sheet the Chinese government has a relatively large stock of net assets and a low debt ratio, and appears to be in a solid position to manage its liabilities. Indeed, according to China’s Academy of Social Sciences, China’s sovereign net assets increased every year from 2000 to 2010, reaching 69.6 trillion yuan — enough to cover the government’s obligations.
However, positive net assets are not sufficient to eliminate financial risk, which also depends on asset structure (the liquidity of assets and the alignment of maturities of assets and liabilities). If a large proportion of a country’s assets cannot be liquidated easily, or would be greatly depreciated by a large-scale sell-off, assets exceeding liabilities does not rule out the possibility of debt default.